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.

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?

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 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 on the list is taxation. Everybody knows this subject. Taxes is what keeps the government alive. Tax rates vary and depends a lot on whoever 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.

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 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 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.

Why are we looking at government bonds in particular? Government bonds are known to be the safest investment giving the highest possible rate of return. It is therefore the best yardstick against which all investments should be measured. If an investment promises only an 8% rate of return on investment, it makes more sense to invest in a government bond that guarantees 8% return rather than risking it in other investments. On the other hand, if a certain investment has a rate of return of over and above 15%, then by all means put your money there instead of in government bonds.

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