return on investment

Return on investment

There are no set rules to arrive at the required rate of return on an investment. We are excluding mathematical models of corporate finance here.

While we have discussed this in the past, it is interesting to see it in the right perspective.

How have you done

Consider that you are investing in an equity asset with Rs.100, and at the end of the year its value goes to Rs.115. Well done, you have earned 15% on your investment.

But before you give a pat on your back, you need to take note of the inflation, treasury bond rate and the broader market.

Only when the inflation is < 15% you have done fine. That is, you have exceeded your purchasing power. This is the first step in measuring your performance.

Next, you check out the treasury bond rate. If your return has exceeded this rate, you have done well. This is your second measure.

Finally, you come to compare your performance with the market itself. If, say, Sensex or Nifty performance for the year is < 15% you have done well.

You should not compare each rate in isolation; it would be misleading.

For instance, if your performance is 4%, market index is 1%, but the inflation is 8%, you have failed in the fundamental principle of investing, i.e. to increase the purchasing power by postponing current consumption.

When you earned 10%, market earned 9%, treasury did 8%, but inflation was 10%, you are left where you were. The monster of inflation has done you - you are left with nothing at the end of the period.

Similarly, if you are able to beat inflation and market, but treasury rates are better than yours over long term, it would still not make sense in investing in equity.

The rules for the expected return and performance

Therefore, the simple rules for the expected rate of return (you can call it discount rate) should be:

1) First, to beat the inflation - you have increased your purchasing power. Give yourself an A;

2) Then, to beat the treasury rates - you have done better (assuming treasury exceeds inflation). Give yourself a AA;

3) Finally, to beat the broader equity index (not sectoral index) - you have done very well. Give yourself a AAA.

Add some stars to your rating depending on the number of points by which you have exceeded the comparable rate.

If the market has under-performed the treasury or inflation, you still got a AAA.

The discount rate

Let's say, once you have estimated the inflation (don't have to break your head for this; historical rates and future economic prospects should be able to guide you), the treasury rates (same analysis), and the market return (same analysis), you simply have to add a few (you choose) points to arrive at your expected return on investment.

Note that if your estimates of inflation, interest rates or the market return are a bit different from the actual in the long term, it's not a big deal since your discount rate is meant to be an estimate not a precise rate.

Well, your discount rates are in front of you. You don't need CAPM or any other model to estimate your cost of capital.