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.
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?
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 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.
These three items will provide us with adequate information for the formulation of 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 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 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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