Before you start on your investments you need to know how much money you want to earn. Of course you want to earn as much as possible, but in this equation we introduce the possibility of losing money, we already have another caution. Thus, it is necessary to mark the risks with the earning potential and set realistic expectations of return.
The return on investment is measured as a percentage
Defining return expectations implies knowing how much we expect to earn with a particular investment. If we want to earn more we must be willing to lose punctually to reach other levels of profitability. In this exercise, we must also know that:
- Return on time deposits is currently less than 1%. If we consider inflation and taxes we have a near zero return. Does it make sense to continue to deposit the money in your bank, even more assuming that it wants to continue taking money from the account in the form of commissions?
- Return on bonds will not exceed 3% in the short term. To have a higher return you have to invest in riskier bonds, which may still be in a level of valuation that resembles a bubble?
- Investing in stocks is what enables higher levels of return on investments. Of course we can have occasional situations with alternative “investments” (note the quotes) such as warrants, futures or very fashionable CFDs. But here we are playing and the probability of losing the whole money in the medium term is very high.
We must realize how the return on an investment is determined
To invest you have to know how the investment works. What are the risks and opportunities? What are the commissions? What we do not know is that we do not have visibility on these variables, we have to know that we are going to lose money (or stop winning, which in the investment world is equivalent).
Here I have a pet hatred for structured products, which I will dedicate to an exclusive article soon. And I do not really like structured products because they are great tools for your bank to take commissions (without realizing it) and sell you a product of poor quality. They are not real products to save money, at least according to our evaluation criteria of savings accounts.
Return is defined in terms of percentage
They often tell us about the return of an investment in absolute value. In euros. And this level of return is misleading because it does not consider the risk we are taking. We easily realize that it is not the same as to have a gain of € 100 in an investment of € 500 or an investment of € 10,000. So if your initial portfolio was € 1,000 and six months past was € 1,150, you know that it performed 15% (1,150 / 1,000) in six months.
The return must be annual
The rate of return of 15% we saw in the previous point was obtained in six months. In this way, it will be valuable to turn that rate of return into an annual rate. In the example, it will be enough to multiply the return of 15% for two semesters, obtaining an annualized rate of 30%. In fact, the rate would be higher if the return was compounded (32%).
How to Analyze the Return
First of all, never forget that past returns are no guarantee of future returns. However, analyzing the historical returns of the different asset classes makes it possible to see how each asset behaves over time. In order to be able to analyze the return rates of an asset we also suggest looking at broad time horizons, since short-term behavior is influenced by a series of factors that cause “noise.”
How to interpret the rate of return?
How do you know if the rate of return is good or bad? How do you know if 3% per year is a satisfactory rate? In practice, the return analysis should be carried out taking into account three realities: what your objectives, what risk you assumed in your portfolio and what market environment at the time. If you had an aggressive portfolio in a time of violent market crash, the return of 3% is extraordinary. However, if you achieved this performance at a time when all asset classes performed extraordinarily, that rate would be less satisfactory.