How would you explain the difference between an investment and insurance? How wo
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Question
How would you explain the difference between an investment and insurance?
How would you briefly explain the difference between a gamble and an investment?
Do you agree or disagree with standard deviation as a measure of investment risk? Explain why or why not in a few sentences.
A brownstone house was bought central brooklyn for $250,000 at the start of 2005, and was sold for $900,000 at the start of 2015. What is the EAR on this investment? Enter your answer as a decimal. For example, 70% should be entered as .70
Explanation / Answer
An investment is when you buy an asset and you expect it to either appreciate in value or produce income or both. The main purpose of an investment is to make profit. Invesments are not used immediately and are usually kept for a period of time before it is sold off.
An insurance protects you from loss. When there is an uncertainty of an event occuring you purchase an insurance for a premium. For example, there might be a risk that you may fall sick. You may not have enough money to pay all the medical expenses in the future. So you purchase a health insurance for a small value. So if you do fall sick in the future the medical expenses will be paid by the insurance agency. Thus, you are transfering the risk to the insurer for a certain fee.
The goals of both, investment and insurance are completely different. The goal of an investment is to increase wealth. The goal of insurance is to protect oneself in case of uncertainty. Investment uses existing money to make extra money. Insurance is to protect your existing money.
Differences between investing and gambling
Standard deviation is the measure of the volatality of the stock. i.e. to what measure the stock price will fluctuate. Standard deviation involves systematic risk and unsystematic risk. Systematic risk is a risk that affects all stocks. Unsystematic risk is company specific. Unsystematic risk can be diversified away. Stocks of different sectors can be included in the portfolio. Thus if some problem affects one sector, at least the other sector companies will balance out the losses. Systematic risk cannot be diversified. Thus an investor is rewarded only for systematic risk. Although standard deviation is used to measure investment risk, systematic risk (beta) is a better option.
Solution:
Initial Value = 250000
Final Value = 900000
n = 10
Holding Period Return (HPR) = Final Value/Initial value - 1
= 900000/250000 - 1
= 2.6
Effective Annual Rate = (HPR + 1)(1/n) - 1
= [(2.6 + 1)(1/10) - 1] * 100
= 0.1367 * 100
= 13.67%
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