How Much Should The Rate Of Return Of Investments Be?

To a majority of investors looking at an investment, the rate of return is an important consideration. When presented with an investment opportunity, the first question they ask is the rate of return. The rate of return of investment is often examined with reference to a certain period of time.

All investors are confronted with the big question of how much the rate of return should be. What is the appropriate or ideal rate of return against which all investments can be measured? For example, your bank suggests you put your money into a time deposit account which pays 5% rate of return compounded annually, how can you tell if it is good investment with a good rate of return?

We need to take into account three important factors to answer that question properly: 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.

Next, what is taxation? We all understand what it is. Taxation is what keeps the government ticking. How much tax we pay varies, depending on whoever is in power.

The third factor is the highest rate of return possible for what is considered as the safest investment – government bonds. Fully backed by the government, they should be very safe. Except when the country is in a political mess, it is unlikely for a government to go bankrupt and therefore, it is also unlikely that the government will turn its back on its obligation.

These three items will provide us with adequate information for the formulation of the ideal rate of return.

In the book \”Buffetology\”, Mary Buffett and David Clark elaborate on the interplay between these three factors. The author reports that Warren Buffett, one of the world\’s richest persons and greatest stock market investor, declares that the minimum rate of return of investment should not fall below 15%. In Chapter 25 of the book, the author wrote that just to absorb inflation and taxation, you need a 7.2% return on investment. Therefore, \”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\”.

Discussing further the effect of inflation and taxation on the rate of return, the author wrote that investing in bonds with an annual compounding rate of return of 8% would probably net a rate of return of only 0.5% (8% less 31% income tax, less 5% inflation). Or zero rate of return even, should the inflation rate rise to 9%. For this reason, if the annual rate of return offered falls below 8%, it does not make sense to invest, government bonds or not.

Warren Buffet knows the importance of having a \”wide margin of safety\”. In keeping with which, he insists on 15% rate of return. Minus 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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