How to judge Investment returns

The Four Conditions of Capital Invested

The four conditions of Capital Invested is a model I came across looking at Real Estate Investments. Its beauty comes from its simplicity, clarity and margin for generalization: it structures and compares investments only based on how hard the capital is expected to work. How do I allocate my capital? In which baskets?

How much of my capital is Dead Money?

How much is Safe Money?

How much is Healthy money?

How much is Wealthy money?

It is a top-down model, designed to inspire investors to look or create investments that provide “more bang for bucks”, even comparing apples to bananas (not immediately looking at the features of the underlying investment). In fact, at this top-level stage – quite correctly – the model does not details gross/net returns, risk-free returns, duration, liquidity, currency, diversification, etc. As such, this top-down approach needs to be integrated with a bottom-up approach (not discussed in this article), based on what each asset class and investment vehicle is chosen.

Inflation and Interest rate

– the model is built on two forces: the inflation rate and the interest rate.

– While inflation is the decline of purchasing power of a given currency over time, the inflation rate is the degree to which the value of a currency is falling and consequently the general level of prices for goods and services is rising. Inflation can be viewed positively or negatively depending on the individual viewpoint and rate of change; high inflation erodes the value of your cash holdings and impacts investment values and returns. Each country or economic area (US, Europe, etc.) tends to have different inflation rates; the same rates change over the years. As such, it is important to know the current inflation rate in your country or in the currencies you invest in and plan accordingly.

– While an average annual inflation rate of around 3 % does not sound too bad, it actually causes prices to double every 20 years (inflation compounds). Inflation effectively decreases the time value of money, since it will cost twice as much to purchase the same product in the future.

– With a 3% inflation, the capital not invested will lose 50% of its value in 20 years. 

– To mitigate this decrease in the time value of money, you can invest the money available to you today at an interest rate equal to or higher than the rate of inflation. 

The Four Conditions of Capital Invested (adjusted)

– The inflation rate and the expected returns quoted in this model refer to the US market in 2016 (with inflation close to 4 %).  As such, while the model provides a good framework, the numbers need to be adjusted based on the country and the year we are analysing.  

– The model was initially designed for real estate investments; it takes into account leveraged investments (using debt) that provide returns over 10-15%. As such, the spectrum of returns and the “qualitative comments” are aggressively skewed.

Therefore, I share an updated model that takes into account a wider variety of Investments returns for 2020. (If you highly invest in developing countries, you need to take into consideration higher inflation; by doing so, you have to adjust the structure of the table and slightly increase the target rate of return of your capital invested).

It is important to remind that a model is a simplified representation of reality; it is created to facilitate certain types of analyses and decisions. Overall, it aims for accuracy, not precision: models are not perfect, but some are useful.

Few Takeaways

– any money in the saving account generate 0 returns. With inflation at 2%, you will lose 2% of the value of your money after one year. As such, it is wise to keep it in the current account and to save the amount of money needed for monthly payments and an adequate emergency fund.

– money invested in most bonds tends to provide annual returns under 2%. Only junk bonds provide a bit more. If the returns are lower than the annual inflation, the investment is not even protecting your principal. However, if this asset class is part of a well-balanced portfolio, it can be smart to own some low-return investments.

– money invested in equity can provide a great variety of returns. Anyway, let’s list few references:

• Warren Buffett company Berkshire Hathaway has returned an annual average return of 20.5% since its began trading in 1965. This is one of the most successful and consistent cases in financial investments.

• S&P 500 US Index stock has returned a historic annualised average return of around 10.5%. This is a popular benchmark for Investments in the stock market. An Investor that wants to “beat the market”, has to do better than the S&P500 for several consecutive years.

– Peer to Peer Lending (P2P lending) or crowdfunding investments can provide annual returns around 5-15%

– Classic Real Estate returns greatly vary depending on the country, the type of property (commercial, family, unit, etc.) and the investment structure. At the retail level, the most used benchmark for “solid/high returns” is around 6-10%.

Final Note

A retail investor can positively look for a variety of investment products that have historical returns in line with his expectations: from 0% to 20%. If you have already calculated your freedom number if you have calculated how long it takes to double your money, you know which returns you need to look for. However, paraphrasing Benjamin Graham,

 “Buying an [investment] only for its yield is like getting married only for the sex”.

Indeed, we will need to look at other parameters before selecting the right investments.

Until next time, Sweat Your Assets.