Every investor has a required investment return. Those who know what their required return is can ensure their investment plan is on track to meet their goals. Those who don’t are likely to be disappointed. My required investment return is to meet my income needs and the rate of inflation. Currently, that means about 5.3% + 1.7% or 7% required return. That way, I’ll be able to continue spending and supporting my lifestyle. I know a doctor who has saved about double what he needs to retire and is still working and saving. His required investment return is around 3%, which is why he can afford to “invest” in GICs and bonds. I have also known people who require an investment return in excess of 10% and are highly unlikely to be able to achieve their goals.
How do you determine your required investment return? There are a couple factors to consider. First, an individual should look at their goals and desired future situation. If a person has a goal to accumulate $1 million (like my 5 year old son), the required return will devolve from the beginning capital and the savings rate. (I have a rate of return calculator that can be used to find the answer.)
In the case of a person with debt, the rate of return should be compared to the cost of debt. Perhaps the required rate of return would normally be 4%, but a person has a mortgage at 5.5%. If the rate of return on investment is lower than the cost of debt, the net worth is actually improving more slowly than it could. The cost of debt sets a floor for the required rate of return.
Other external factors may also set a floor. For example, inflation and taxes. In the case of a 3% GIC, roughly half the interest (or 1.5%) will be paid in taxes. If inflation is 1.5% or higher, the owner of the GIC is actually losing money in real terms. In this case, the required return is at least two times inflation.
Finally, the required return may be related to risk. If government bonds are guaranteed to pay me a 2% annual return, I will refuse to invest my money in a riskier investment if my expectation is a return of only 2%. Of course, there’s almost no science to future investment returns. Imagine that I suspect that a given investment has an 80% chance of success and a 20% chance of failure. The mathematical expectation is 80% times the expected return, which I might guess is 7%. (7 x 0.8 = 5.6) 5.6 is better than inflation and better than my cost of capital, so I may make the investment. I would also expect that I would lose my money 1 time in 5 (should I repeat this investment), so I wouldn’t invest the entire amount.
Being clear about a required investment return is an important factor in responsibly managing capital. It may not be possible to predict future returns, but it is possible to identify and minimize risks.