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What Is The Optimum Rate Of Return Of Your Investments? |
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Written by ZigfredDiaz
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Saturday, 27 February 2010 |
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One of the top items considered very carefully by investors when looking at investment packages is the rate of return. It is not surprising that the first question they ask for when presented with an investment proposal is the rate of return. The rate of return is evaluated with reference to a certain period of time.
by ZigfredDiaz
One of the top items considered very carefully by investors when looking at investment packages is the rate of return. It is not surprising that the first question they ask for when presented with an investment proposal is the rate of return. The rate of return is evaluated with reference to a certain period of time.
How much should the rate of return be? That's a question all investors keep asking. Is there a universal standard or ideal rate of return by which you can measure all investments? When your bank talks you into putting your money into a time deposit account that generates 5% rate of return compounded annually, how do you know that it is a good investment with a good rate of return?
Three factors need to be taken into consideration if we are to answer the question properly: inflation, taxation, and the highest rate of return possible for the "safest investment" of all.
To begin with, what is inflation? Wikipedia says it is "a rise in the general level of prices of goods and services in an economy over a period of time". Inflation nibbles at the value of money. Your P1000 now may not be worth much 20 years from now because of rising prices of good and services. Your P1,000 three years from now won't be able to buy the things you can buy for P1,000 today.
The second item in consideration is taxation. It needs no discussion as everybody knows taxes. Tax rates vary as it all depends on who is in power.
The third consideration is the highest rate of return for what is believed as the "safest investment" which is, of course, government bonds. These are considered very safe by the very fact that they are fully backed by the government. Since it is unlikely for a government to go bankrupt except when it is in political turmoil, it is inconceivable that it would renege on its obligation.
Together, these three factors will come into play when computing for the ideal rate of return.
Mary Buffett and David Clark explain in the book "Buffetology" the interplay between these three factors. According to Warren Buffett, one of the world's wealthiest and greatest stock market investor that the minimum rate of investment should not fall below 15%. In Chapter 25 of the book, the author estimated that just to cushion inflation and taxation, a 7.2% return on investment is needed. The book concludes 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".
They wrote further that investing in bonds with an annual compounding rate of return of 8%, you would probably net a rate of return of only 0.5% (8% less 31% income tax, less 5% inflation). If the inflation rate increases to 9%, then you will get a zero rate of return. It does not make sense then to invest in government bonds or in any investment that offer an annual rate of return below 8%.
Warren Buffett believes in the having a "wide margin of safety". That is the reason why he insists on a 15% rate of return. Net of inflation and taxes, he is assured with a growth of about 8% rate of return compounded annually.
What makes government bonds an interesting consideration? Not only are they the safest investments but also they give the highest possible rate of return. Thus it has become the standard by which all other investments are measured. So if an investment can give only an 8% rate of return, it is better to invest in government bonds that guarantee 8% return on investment, rather than risking it in other investments. Should you find however, that a certain investment has a rate of return of over and above 15%, then put your money in that investment rather than in government bonds.
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