What is the ideal rate of return for investments?
In previous posts, we have learned all about the Rule of 72. One lesson that we have learned about the rule is that the higher the higher rate of return for a certain vehicle of investment, the shorter the time it takes for money to double.
So the question that faces us now is what is the ideal rate of return for investments? How do I determine the ideal rate of return of investment?
Before we delve into the topic let us first discuss the concept of rate of return of investments.
Rate of return according to Wikipedia is “the ratio of money gained or lost (realized or unrealized) on an investment relative to the amount of money invested.” In finance parlance, most often it is called as “Rate of return of investment”
Majority of investors view rate of return as an important thing to consider when scrutinizing an investment. More often, “rate of return” is the first question usually asked when an investor is presented a certain investment. Rate of return of investment is often associated with a certain period.
The big question that all investors face is this, how much is the appropriate rate of return? What is the appropriate, ideal or rate of return wherein all invested should be measured against? For instance if your bank tells you to put your money in a time deposit account growing at 5 % rate of return compounded annually, can you consider this a good investment with a good rate of return ?
To properly answer this it is necessary that we seriously consider three things. These are inflation, taxation, and the highest rate of return for what is considered as the “safest investment.”
So what is inflation? Wikipedia defines it as “a rise in the general level of prices of goods and services in an economy over a period of time.” Inflation eats away the value of money. P 1000 now may not what it may be worth 20 years from now because of the rise in prices of good and services. You may probably not be able to buy 3 years from now what you can buy with your P 1,000 today.
Secondly let’s talk about taxation. Of course everybody understands this subject. Taxation is the lifeblood of the government. The rate as to how much the tax is will vary depending on who is in power.
Thirdly, the highest rate of return which is also considered as the safest investment is of course government bonds. Government bonds are considered very safe because these are backed by the government. It unlikely that a government will go bankrupt (Except of course of a country is in political turmoil) hence it is unlikely that the government will renegade on its obligation.
Putting all of these three together, we are then provided with a clue on how to compute the ideal rate of return.
In the book “Buffetology,” Mary Buffett and David Clark discusses extensively the interplay between these three factors. (For those of you who want to get a copy of the book Buffetology click here to get it at my Guerilla blogger eStore)
In that book the author reveals that Warren Buffett insists that the minimum rate of return for a certain investment should not fall below 15 %. In Chapter 25 of the book they wrote that just to stay even with inflation and taxation you would need a 7.2 % return on investment. Because of this they come to the conclusion that “to have a real increase in your wealth, it is necessary that the return on your wealth be at least equal to the effects of taxation and inflation.”
For those of you who do not know Warren Buffett, he is one of the world’s billionaires and probably the only billionaire who derived his riches from solely investing in stocks. We will discuss more about him in future post.
They take the discussion further by stating that if you invest in bonds with an annual compounding rate of return of 8 % you would probably end up with a rate of return of only 0.5 % (8 % less 31 % income tax, less 5 % inflation) If the inflation rate goes up to 9 % then you end up with a zero rate of return. Hence, it can be concluded that it makes no sense to invest in government bonds or any investment for that matter that offer an annual rate of return below 8 %.
Warren Buffett loves the concept of having a “wide margin of safety.” That is why he insists on 15 % rate of return. Less inflation and taxes, he is always ensured of a growth of about 8 % rate of return compounded annually.
Since the authors are American they have assumed their own inflation rate of about 5 % and an average tax on income of 31 %. To apply what they disccused, let us look at our own average inflation and tax rates. Most financial planners hold the view that the average inflation rate is at 7 %. Taxes, etc. is about about 13 %. In short we need about 7.1 % to stay even with inflation, taxes and trading fees.
Since we need about 7.1 % rate of return to stay even with inflation and taxes. Similarly we must also insist on a 15 % return just as the authors suggested.
With regards to why we should consider government bonds, well the answer to this is simple. Government bonds are considered as the safest investment there is that can give the highest possible rate of return. Hence all investments should be measured against the rate of return of government bonds. So if in your calculation an investment will only give a 8 % rate of return for your investment then it is better to invest in a government bond that gives a consistent 8 % return considering the risk involved if you invest it in other investments. However if you think that the rate of return of a certain investment is over an above 15 %, than it is much wiser to put your money in that investment rather than government bonds.
So there you have it! The ideal rate of an investment is 15 %. The question now is where on earth are we going to get a vehicle investment that gives you a return of 15 % or more? Find out in the next post entitled “Investments vehicles that yield 15 % return.”
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