How to judge Investment returns

The Four Conditions of Capital Invested | Investment Returns

The four conditions of Capital Invested are a model I came across, looking at Real Estate Investments.

Its beauty lies in its simplicity, clarity, and margin for generalisation: it structures and compares investments solely 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 for 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 detail 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 the features of each asset class and investment vehicle.

Inflation and Interest Rate | Investment Returns

The model is built on two forces: inflation and interest rates.

While inflation is the decline of the purchasing power of a given currency over time, the inflation rate is the degree to which the value of a currency is falling.

Consequently, the overall price level for goods and services is rising. Inflation can be viewed positively or negatively, depending on the individual’s viewpoint and the rate of change; high inflation erodes the value of cash holdings and affects investment values and returns.

Each country or economic area (the US, Europe, etc.) tends to have different inflation rates, and those rates change over time. As such, it is important to know your country’s current inflation rate and the currencies you invest in, and to plan accordingly.

While an average annual inflation rate of around 3 % does not sound too bad, it 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 3% inflation, capital not invested will lose 50% of its value over 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 inflation rate.

The Four Conditions of Capital Invested (adjusted)| Investment Returns

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 must be adjusted for the country and year we are analysing.  

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

Therefore, I share an updated model that considers a wider variety of Investment returns for 2020.

If you invest heavily in developing countries, you need to consider higher inflation; accordingly, you will need to adjust the table structure and slightly increase the target rate of return on your capital.

It is important to remember 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 savings account generates 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, save the money needed for monthly payments, and maintain an adequate emergency fund.

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

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

• Warren Buffett’s company, Berkshire Hathaway, has returned an annual average return of 20.5% since it 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 stock market investments. An investor who wants to “beat the market” has to outperform the S&P 500 for several consecutive years.

– Peer-to-Peer Lending (P2P lending) or crowdfunding investments can provide annual returns of 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 look for investment products with historical returns in line with their expectations, ranging from 0% to 20%. If you have already calculated your freedom number and 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.

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Until next time, Sweat Your Assets.