Maximizing Your Investment Returns

Taken from On Target 264

The first thing most people look at when considering an investment is the annual rate of return they expect to be able to make out of it. Return is the “rent” you enjoy as payment for investing your capital rather than going out and spending it, and also the “reward” for the risk you take.

The return usually, but not always, consists of two parts – income and capital. The cash element is usually paid annually or more frequently, but is easily understood as being at an annual rate. The capital element of the return – the profit you make when selling an asset compared with what you paid for it – should always be converted at an annual rate and regarded as return in exactly the same way as income.

Return taken in the shape of a capital gain has the advantage over most kinds of income in that it is usually tax-free or taxed at a lower rate. But income offers the advantage for many of being in the form of a steady and stable flow of cash. You can always sell a portion of a capital asset for cash, but that becomes tiresome if you need to do so every month.

In considering any investment, you should add together the income and the capital gain you expect to make, and express that at an annual rate as a percentage of the capital value of your investment.

The capital you invest includes not only the “price” of the investment, but also the cost of making it. For example, if you buy shares, in addition to paying the price of the shares asked by the seller, you also have to pay costs such as brokerage fees and duty charges. Return should be calculated, not on the selling price of the shares, but on their total cost including all charges and taxes.

There are several pitfalls to watch for when comparing the rates of return offered by different investments. What professional advisers tell you is not necessarily the whole story.

Firstly, there is the compounding factor.

When making an investment you are entitled to a return on the return itself, unless you are drawing all the return in cash, as in the case of interest paid on a loan stock. It is usual to assume that the return you enjoy on your ploughed-back return is at exactly the same rate as the return on your original capital investment.

There can be an enormous difference between a COMPOUND rate of return and a SIMPLE one, as the following example shows.

Suppose the value of an asset such as an extremely rare antique is expected to increase from $1,000 to $10,000 over ten years.

It may be claimed that the average annual rate of return on money invested in such an asset would be 100 per cent as $1,000 increasing at 100 per cent a year will accumulate to $10,000 after ten years. In fact the figure would be 25.9 per cent. If the asset yielded an average annual rate of return of 100 per cent, taking into account ploughing-back of return each year as well as the value of the original capital, its value after ten years would not be $10,000 but… $1,024,000!

You should always use compound rates of return to compare investments. It’s easy to calculate them using a financial calculator.

A second pitfall to watch out for when making comparisons is inflation.

If you invest $1,000 in a fixed-interest security yielding say 2 per cent and plough back your return every year, but inflation averages 4 per cent a year, then after ten years your original capital will have grown to $1,219 – but its purchasing power will be only $817 in today’s money.

It is important to differentiate between a nominal or ordinary rate of return (one that has not been adjusted to take inflation into account) and a REAL rate (one that has been adjusted for inflation).

Making accurate comparisons of rates of return

When comparing such rates it is common to ignore sometimes substantial differences between the buying and selling prices of the asset. You should always try to estimate this difference – the buy/sell margin – and adjust downwards your forecast rates of return to allow for that.

Another pitfall – affecting all investments that produce a regular cash income – is that you cannot make an accurate comparison of rates of return unless you know the frequency of payment or calculation of interest that is automatically reinvested (annually, quarterly, monthly, daily?), and whether it is paid in arrear (the usual basis) or in advance.

For example, a 10 per cent rate paid annually is worth 10 per cent, but if it’s paid half-yearly, it’s actually worth 10.25 per cent; if quarterly, 10.38 per cent; if monthly, 10.47 per cent; and if quarterly in advance, 10.64 per cent.

So before putting your money into any fixed-income investment, find out first how frequently the income accrues, and whether you will be paid in arrear or in advance. It does make a difference.

Rates of return vary from one investment to another because they reflect varying factors such a risk and liquidity (ease of conversion into cash). They also vary from time to time as circumstances change.

It is possible to lock yourself into fixed nominal rates of return from certain kinds of investments, but this in itself carries an inherent risk that rates offered on the same investments, newly made, may rise, leaving you stranded earning a lower rate.

Forecasting a rate of return is always tricky, but you should take a crack at it if you want to compare alternative investments. At the very least, it will alert you to some of the dangers and opportunities in particular investments.

Maximizing Your Investment Returns taken from our ‘On Target Newsletter’ issue no 264