What About Rate of Return?

Back in the  ’80’s there existed a financial advisory firm that could make anyone’s financial plan work.  Need more, can only save a little, or have a only a little time to retirement?  No problem, we can make it work for you.

A pretty compelling presentation for people who do not pay attention to reality.

Yesterday I talked about the triad of financial planning factors.  Capital, yield and time.  Before creating a financial plan, you should have a clear idea about all three. What capital can you contribute, what time and what realistic yield is your knowledge, access to investments, management skills, time to do so, and many other variables.

Suppose I know that I need capital available in 30 years.  And, further suppose that I know what investments are available to me.  I will discover that availability is only part of the question.  There are some things I should not buy.

For example, I might notice rental real estate.  I have studied carefully and know that I can earn a 10% return, cash on cash, and I can have a tax shield from depreciation in the early years.  In 30 years, I can easily have it paid for and could have the net income to live on forever, mostly inflation proof too.  Maybe even a capital gain when I sell.  So why not buy up as many as I can afford?

Two reasons:

  1. There are not that many available that have the right price/yield characteristics.
  2. I have no skill, patience or inclination to be a landlord.

So even though a triplex might be a good investment, it is not a good investment for me.

Knowing what is a good investment, for me, is important pre-knowledge.  Think it through before talking to an adviser.

This failure to think through what was possible, was the key to the “We can solve anyone’s financial planning problem.” They just assumed whatever rate of return they needed.

“Given your needs and available capital, we can make it work for you if you get 16.5% on your money over the time to completion.  And, fortunately for you, we have available a fund that made more than last year so it would be conservative to assume they can get what you need next year.”

For a naive investor, that might make sense.  It will not happen, but that is what the naive requirement is for.  Losing time while the fallacy comes clear is very costly.

As a client, before you decide how to proceed, know what you need to get, when you need it, what you have to get it with, and finally, what yield you can expect from the part of the investment universe that matches your skills and inclinations.

Every investment provides the same return on investment if you consider all the factors invested.  If you want something with no effort or skill and no risk, you must accept a very low rate of return.  Money by itself does not earn much.

A simple example.  A five year investment certificate pays more interest than a one year certificate.  Reason?  You invested the same amount but in the five year certificate, you gave up the right to have the money longer (liquidity) and maybe took a little risk because it is harder for the issuer to survive five years than one.   The difference in the rate is the price of liquidity and risk for that particular investment.  If you cannot accept the risk and the illiquidity, you cannot have the extra yield.

Investment fit is like buying shoes.  There are lots to choose from but you won’t like all of them and some of the ones you like, won’t fit. Yield measures fit.  It is about what you get back for what you put in.

Most investors have not thought through yield and where it comes from.

Investment yield depends on many factors.  Easily thirty. The best result comes when you can find an investment that matches all your pluses (the things the market will pay you to provide) and none of your minuses (the things the market will make deductions from yield if you want them.)

Do not skip the step that says, “What is a reasonable yield for me?”

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

don@moneyfyi.com  |  Twitter @DonShaughnessy  |  Follow by email at moneyFYI

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