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.
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 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.
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.
Together, these three factors will come into play when computing for 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".
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 Buffett believes in the having a "wide margin of safety". That is the reason why he insists on a 15% rate of return. Net of 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. - 31970
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 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.
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.
Together, these three factors will come into play when computing for 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".
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 Buffett believes in the having a "wide margin of safety". That is the reason why he insists on a 15% rate of return. Net of 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. - 31970
