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.
There is a question that all investors ask inevitably: how much can be considered appropriate rate of return? How much is the best or ideal rate of return by which we could measure investments by? When the bank tells you to save your money in a time deposit account because it pays 5% rate of return compounded annually, how can you tell that you are making a 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.
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.
Using these three factors, we now have the complete inputs to the process of computing the ideal rate of return.
In the book “Buffetology”, Mary Buffett and David Clark explain the interplay between these three factors. They quoted Warren Buffett, one of the world’s richest persons and greatest stock market investor as saying that the minimum rate of return of investment should not fall below 15%. The author wrote in Chapter 25 that just to even up with inflation and taxation, a 7.2% return on investment is needed. The book concludes, “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 insists on 15% rate of return because he loves the concept of having a “wide margin of safety”. After inflation and taxes, it guarantees him 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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