Determining the best rate of return for investments

I have answered several questions from a student from the University of the Philippines-Cebu regarding investing in the Philippine stock market. So far my answers are contained in the post entitled “Questions and answers on the Philippine stock exchange” and “The best asset allocation strategy to follow.”

As I have previously noted, since the question asked requires somewhat lengthy answers, I have decided to turn it into a series of blog posts for several reasons. First, so that I can have something to post in my blog, secondly, for keyword ambush 🙂 and thirdly to somehow share knowledge and awareness to the public with regards to the stock market and value investing.

One of the questions asked was that if assuming a 20 % rate of return in the stock market is practicable. Here is my answer to the question.

Dear Enji

Rate of return or otherwise known as “rate of return of investment” is defined by Wikipedia as “the ratio of money gained or lost (realized or unrealized) on an investment relative to the amount of money invested.”

Most investors view this as one of the most important factors to consider when considering an investment. In fact “rate of return” is the first question usually asked when an investor is presented with an investment proposal. Rate of return is often associated with a certain period.

Most value investors in the stock market adhere to a “buy and hold” strategy hence rate of return is often computed annually. They also “re-invest” what they have gained. This is popularly known as “compounding.” Hence most value investors compute for the “rate of return compounded annually”

So the question that not only value investors but all investors face is this, how much is the appropriate rate of return? What is the “bench mark” rate of return wherein all invested should be measured against? For example of your bank tells you to put your money in a time deposit account growing at 5 % rate of return compounded annually, is this considered a good investment ?

To answer the question properly we need to consider three things. These are inflation, taxation, and the highest rate of return for the safest investment.

Wikipedia defines inflation as “a rise in the general level of prices of goods and services in an economy over a period of time.” It eats away the value of money. P 100 now may not what it may be worth 10 years from now because of the rise in prices of good and services.

Taxation of course is what the government gets from its citizen. Taxation is adjustable depending on the whims of those sitting in government.

The highest rate of return for the safest investment is of course government bonds. The reason for such is because these are backed by the government so unless the government goes bankrupt then it is unlikely that the government will renegade on its obligation.

So how do these three factors provide the clue in computing for the appropriate rate of return?

The interplay between these three factors is comprehensively discussed in the book “Buffetology” by Mary Buffett and David Clark. (For those of you who want to get a copy of the book Buffetology click here to get it at my Guerilla blogger eStore) According to the authors, Warren Buffett insists that the minimum rate of return for a certain investment should not fall below 15 %. The reason for such is explained in Chapter 25 of the book. According to the authors, just to stay even with inflation and taxation you would need a 7.2 % return on investment. They have further concluded 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.”

The authors continue further that if you invest in bonds with an annual compounding rate of return of 8 % you would end up with a rate of return of only 0.5 % (8 % less 31 % income tax, less 5 % inflation) If inflation rate is adjusted to 9 % then you end up with no rate of return at all. So with this in mind, it makes no sense to invest in government bonds or any bond for that matter that offer an annual rate of return below 8 %.

Buffett loves having a wide margin of safety and his definition of a margin of safety is always 50 % more, that is why he insists on 15 % rate of return. Less inflation and taxes, he is always ensured of a growth of about 8 % rate of return compounded annually. (By the way he insists in a holding period of “forever” to avoid taxes. So he barely sells his acquisitions)

In Buffetology the authors have assumed an average inflation rate of about 5 % and an average tax on income of 31 %. These rates are applicable in the American setting. However in the Philippine setting most financial planner holds the view that the average inflation rate is at 7 %. Taxes, PSE fees etc. amounts to about 13 %. This tells us that we need about 7.1 % to stay even with inflation and taxes.

Since we need about 7.1 % rate of return to stay even with inflation and taxes therefore we ought to insist on a 15 % return just as the authors suggested of Buffetology suggested.

With regards on why it is important to consider government bonds, since these are considered as “stable” and “safe” then it makes sense that any investment offered should be measured against the rate of return of government bonds. For example if you calculated that a stock will only give a 8 % rate of return for your investment then it is better to invest in a government bond that gives a consistent 8 % return considering the fluctuations in a stock market investment. But if you are somewhat certain that the rate of return of a certain stock is over an above 15 % than it would be wiser to put your money in the stock market, rather than government bonds.

Now that we have learned that the minimum rate of return that we should insist for an investment should be 15 %, we go back to your original question if it is possible to get a 20 % rate of return in the stock market.

Warren Buffett has an average rate of return of about more than 20 % compounded annually (His average rate of return for his partnership from 1957 to 1969 is 29.5%. The average rate of return of his holding company, Berkshire Hathaway is almost 20 % since the 1990s. (This means that $1,000.00 invested with Buffett in 1957 would estimated to be worth $20,283,868.03 in 50 years at 20 % per annum)

So if the Oracle of Omaha can get a 20 % compounded average rate of return per year is it possible to get this kind of rate of return in the Philippine stock market?

Of course! Value investing principles works in any kind of stock market environment. I wrote a post entitled “Applying value investing in the Philippine stock market.” You can see in there that investments in Jollibee, Globe and Megaworld Corporation from 1997 to 2007 would give you an annual compounded rate of return of more than 25 % per annum. So you can see that it much better to buy stocks than cell phones.

So with regards to the question if a 20 % annual compounded rate of return is reasonable, the answer is in the affirmative. However to be on the safe side, just assume a 15 % rate of return just as Buffett does. If it turns out to be more than that, which probably will be as what Buffett has experienced than you make your customers very happy indeed. Always follow the principle of “Under promise, over deliver.” 🙂

I’ll answer your questions on diversification and security selection in another post.

Sincerely,

The Guerilla Investor 🙂

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Hi ! my name is Zigfred Diaz. Thanks for visiting my personal blog ! Never miss a post from this blog. Subscribe to my full feeds for free. Click here to subscribe to zdiaz.com by Email

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