It's really simple–the reason you make an investment is because you anticipate a return. You expect to earn something—income (interest, dividends) and/or appreciation (capital gains)—and those earnings are your return on your investment. When we express that return as a percentage of the investment's cost, we define its rate of return.
Before we go further in our discussion of rate of return, let's review what we've learned so far about the elements of an investment, and our chart at right. First, remember that this is meant to be a personal rating system; thus, your scoring of an investment's rate of return will depend on a variety of factors including your age, investment knowledge and position in the wealth cycle (see Jerry's Corner–The Wealth Cycle). Next, each element is meant to interrelate to the other eight elements, and all nine elements should be considered when you determine the appropriateness of an investment. Finally, we rank each investment category from zero to ten. For rate of return, a "zero" would mean this investment shows no return, while a "ten" would indicate an investment with a very high return.
When you evaluate an investment you are contemplating—but have not yet made—you will be judging the investment's expected return. That is the income and appreciation you expect to earn on this asset. In the case of a bank CD offered at a published rate, you can accurately predict exactly what that rate of return will be.
On the other hand, the rate of return for many investments cannot be accurately known until after the investment is sold and converted to cash. At that point you will know the investment's realized return. The realized return may, of course, be quite different from the expected rate of return. The difference is the element of risk.
Thus, the expected return is your incentive for accepting risk. Virtually all investors have a common attitude toward risk—they don't like to bear it. Therefore, the expected return from an investment (its rate of return rating) must be sufficient to compensate you for assuming the risk inherent in the investment.
Let's now turn our attention to our chart and review our scores for the rates of return of various investments. Savings and money market investments offer only one of the two components of return–they produce income but not appreciation. As such, they receive a relatively lower ranking for rate of return for failing to provide a hedge against inflation. Bonds possess a similar, fixed-income return, often at higher rates. They also have the potential to appreciate (or lose value) in a changing interest rate market. Thus, bonds score slightly higher in our grid.
Stocks and stock mutual funds fare better on our scale in that they can be chosen for income, appreciation, or both. Historical yields—the basis for determining expected returns—show that these investments have traditionally out-performed savings and other fixed-income instruments.
Let's dwell a moment on rental real estate in order to demonstrate an important facet of rate of return. That is, how you can affect an investment's return. When you choose an investment over which you may exercise your entrepreneurial discretion—such as in the management, improvement, expense control or best use of the underlying asset—you achieve a measure of control over that investment's return. For instance, when you choose to handle the repairs, maintenance and management on a rental property (rather than pay a property manager and handy-man) you decrease expenses and increase rate of return.
These same control factors contribute to the relatively high score for the return on your own home, even though it is a fairly low-risk investment. Commodities and limited partnerships, on the other hand, achieve their high return ratings through increased risk. Finally, don't forget tax advantages (depreciation on rental property, mortgage interest deduction on your home, deferral of capital gains) when totalling up your overall return on an investment.
In the end, we see that rate of return—too often the only consideration of some investors—is simply one of several elements you will consider when choosing an investment.
Elements of Investment
Elements
Savings & Money Markets
Stocks
Bonds
Limited Partnerships
Real Estate
Commodoties
Home
Risk
8
6
7
2
5
2
9
Management
8
7
7
9
4
5
7
Flexibility
4
8
7
1
5
2
7
Liquidity
9
8
7
1
6
1
7
Cash Flow
4
5
6
1
7
1
7
Rate of Return
4
7
5
6
7
8
8
Appreciation
-
-
-
-
-
-
-
Leverage
-
-
-
-
-
-
-
Taxes
-
-
-
-
-
-
-
Total
-
-
-
-
-
-
-
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Moorman and Company, an accounting and personal financial management firm based in Palo Alto, serves the San Francisco Bay Area, Peninsula, and Silicon Valley from Hillsborough to Saratoga-Los Gatos, including Atherton, Menlo Park, Los Altos, Los Altos Hills, and Cupertino.