A good rule of thumb that I use to understand returns on investments (monetary or otherwise): the amount of return* you receive is affected by time of the investment, risks involved, skills utilized, capitals deployed, and a random factor, luck.
Return = f(Time, Risk, Skill, Capital, Luck)
Time - is how long the investment ran. The longer it is the better the return tends to be, ceteris paribus. Or in other words, it is easier to get better returns over larger periods of time. A 10 year buy-and-hold strategy is apt to yield better overall return than a split-second stock trade. Longer time periods mitigates risk.
Risk - is how exposed the investment is to the possibilities of loss. The higher it is the better the return tends to be, ceteris paribus and provided it does not flop. Striking out on your own as a fledgling entrepreneur can yield a significantly higher return than going to an MBA program, but having the degree makes it much easier to land a good job, which is safer and more stable.
Skill - is the amount of expertise (technical or otherwise) utilized in the investment. The higher it is the better the return tends to be, ceteris paribus. Given the same time, equipment, and constraints, you are more likely to learn car handling better if you learn from The Stig as opposed to your local driving school teacher.
Capital - the amount of capital (usually something of monetary value) committed to the investment. The higher it is the better the returns tends to be, ceteris paribus. A $10 Google Adwords usually reaches less intended audience than a $4,000,000 Super Bowl ad, no matter how targeted it is. Capital may be used as substitute to either time or skill.
Luck - there’s a reason why we say “Good luck on your __”. A good luck can make up for all the deficiencies in the investment; a bad luck can cause loss in what otherwise is a good business.
* By return, I am talking about the final result of what is attempted. For lack of a clearer term, I am calling it ‘holistic return’, i.e. the whether or not you passed that test you’re studying for, or how much life satisfaction working for 20 years in corporate finance brings. This is in contrast with ‘relative return’, i.e. a 1% return in a day is relatively higher than a 20% return in a year, but as a whole, the 20% return is better.
Finally, you may as well skip this article go watch The Big Short to see the formula in action.
Last updated: 8 Sept 2017