We will begin by establishing the most important variables you should consider when selecting a group of shares for an investment portfolio. There are three main factors you should be concerned about when selecting one investment over another. These include:

1. The compensation delivered to your money in relation to how long you have deferred consumption for – known as the time value of your investment (Refer to How does money gain value over time?)
2. The expected inflationary rate for the period in which you are choosing to invest (Refer to How does money gain value over time?)
3. The risk reward concept (Refer Risk Reward Tutorial)

Once these three points are summed together you can get an accurate indicator of how much you have actually made on your investment – termed Required Rate of Return. This is the minimum rate that you will accept from any investment for giving up your money now.

Your Rate of Return (ROR) can be calculated using the following ratio – but the degree to which you feel it is your Required Rate of Return, depends on how much you feel your deferred consumption is worth.

For example, if you defer consumption of $10,000 dollars to purchase shares that are valued at $5 dollars each. This will mean that you will receive 2000 of that particular share. Now, if the share price rises to 8 dollars, then your investment is now worth $16,000 - calculated by the new share price times the share quantity you hold. Thus, your Rate of Return (ROR) becomes:

Whether this figure is your Required Rate of Return depends on whether you believe your deferred consumption has been adequately compensated for with respect to the risk-reward concept and current inflationary rate. In the above example, a ROI of 60% is clearly a very good return however it may not be as rewarding if it has taken 10 years for you to achieve this rate, in a high inflation period with a considerable amount of risk. You may have been able to invest in other risk adverse investments, which would have provided a better ROR and ultimately achieve a higher return. This however, is the nature of investing and the risk-reward concept.

The most commonly heard investing expression “Time is Money” is a true indicator of the nature of beast - Time literally is money. This basic concept is derived from peoples willingness to save or spend - essentially it is trade-off between the two.

You have the choice whether to defer expenditure now (save) in order to receive a greater amount in the future, or consume more now (borrow) with the realization that more needs to be paid back into the future. This is what drives the pure rate of interest in our economy - the rate of exchange between future consumption and current consumption - which is a comparison of the savings to be invested and the demand for borrowings to be acquired at any given time. If you save (or borrow) $100 today and expected to get (give back) $105 in the one years time, the pure rate of interest would be 5%(105/100 -1).

The pure rate of interest is known as the real rate of  interest rate which is the effective growth of your purchasing power and is not usually quoted in the media -  they use nominal rate of interest - and it is the real interest rate, that as an investor, you want to look out for because the real rate is the increase in your available purchasing power.

The nominal rate of interest is the real interest rate plus inflation. Inflation decreases your purchasing power and erodes the value of your money and therefore what you can buy. It is influenced by many different economic factors but mainly by the demand of goods growing faster than the rate at which the goods can be supplied - effectively driving prices up. If you had $100 dollars in saving, and expect to get back $105 in 1 one years time but inflation was at 2% - then you would want to get $107 or a 7% nominal interest rate to compensate for inflationary rate.

Example: If the Real Rate is 7% and the Nominal is 10% - Inflation is at 3% (10% - 7% = 3%)

Generally, a small level of inflation means that the economy is growing, and a weakening inflation rate means that the economy is becoming weaker - whether inflation is good or bad for you depends ultimately on the position of the Australia economy and your personal situation. The Reserve Bank of Australia, usually keeps inflation maintained at low constant rate.

The most important fact to be aware of regarding inflation is that when you are looking at investment returns - you want the real rate not the nominal!