How Much Should The Rate Of Return Of Investments Be?
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?
To answer this properly, three factors need to be considered seriously: inflation, taxation and the highest rate of return for what is considered as the “safest investment”.
To start with, what is inflation? Wikipedia calls it “a rise in the general level of prices of goods and services in an economy over a period of time”. Inflation erodes the value of money. Your P1,000 now may not be worth much 20 years from now because of the constantly rising prices of good and services. Three years from now and you probably may not be able to buy what you can buy with your 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 factor to be considered is the highest rate of return for the safest investment ever known which are government bonds. Government bonds are safest since they are naturally fully backed by the government. It is highly unlikely that a government will go bankrupt (unless the country is in the middle of a civil war or political turmoil) therefore it is also unlikely that the government will renege on its financial obligations.
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”.
Focusing on the effect of inflation and taxation on the rate of return, the author cautioned that investing in bonds with an annual compounding rate of return of 8% would probably leave a rate of return of only 0.5% (8% less 31% income tax, less 5% inflation). Or worse, zero rate of return if the inflation rate rise to 9%. In conclusion, it does not make sense then to invest in government bonds or in any investment if the rate of return offered is 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 is special about government bonds that we are seriously considering it? Not only are they known to be the safest investment but it can also give the highest possible rate of return. Thus it is the standard by which all other investments can be measured. So if in your evaluation, an investment can only give an 8% rate of return for your investment, you would be a lot better off investing in a government bond that guarantees 8% return on investment, rather than risking it in other investments. But if 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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