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When evaluating an investment, most investors consider rate of return as an important criterion. Thus when presented with an investment proposal, the first question usually asked is the “rate of return”. Rate of return of investment is often linked 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?
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”.
First off, what is inflation? According to Wikipedia, it is “a rise in the general level of prices of goods and services in an economy over a period of time”. Inflation gnaws at the value of your money. So your P1,000 now may not be worth the same 20 years from now because the prices of goods and services keep increasing. Your P1,000 3 years from now may not be able to buy as much as you can buy today for the same cost.
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 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.
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 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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