We can talk about a subject that is near and dear to most people’s heart and mind – making money. There are two basic ways to making money. The first is to work for it. The second is to let your money do the work for you. This latter approach is the basic concept behind investing. One of the numbers that investment firms, financial news stations, and business articles focus on is an investment’s “rate of return.” Simply put, it is the amount of money you expect to gain on your investment over a specific period of time. That gain is expressed as a percentage. If you make $5 on a $100 investment, your actual rate of return is 5%.
But there is more to understanding the rate of return than just the basics. A rate of return can be a negative number. While you are not likely to invest in something that will lose you money, the possibility exists. Also, a rate of return just doesn’t apply only to money. It can include real estate, fine art, or anything that can increase in value over a specific period of time. The popular and commonly accepted idea is that numbers don’t lie. So when an investor looks at a rate of return and sees it is positive, the tendency is to have a certain amount of confidence in the financial future of the asset. Reading about a stock that has increased by 10% presents the idea it is a good investment.
But rates of return are for a specific period of time. If you are looking at a rate of return of 10%, it may be only for the last quarter or year. The wise step to take is to look at the asset’s performance over a number of years before making any decision to invest. The long term history is a much better indicator of the asset’s price performance than a shorter period, such as 90 days. This takes a bit of homework on your part, but it will be time well-spent.
Another consideration when looking at the rate of return is to determine whether the asset is a good fit for your complete financial portfolio. The idea of not putting all your financial eggs in one basket had held true for many years. If your portfolio primarily consists of conservative investments that guarantee you a solid rate of return on a regular basis, choosing to buy a stock that offers double or triple the rate of return on your current portfolio can be looked at in two ways. One is that it goes against the grain of your entire portfolio, so it is an unwise decision. The other is that you can afford to take some risk – and it is about time to do so. The decision is not one of simply numbers, but of what your personal financial goals are.
Once you make the initial decision to take advantage of the investment opportunity, it is vital to calculate any and all expenses and fees associated with the investment. Depending on those numbers, the actual rate of return can be considerably lower than advertised. Do not forget that some investments such as stocks may deduct fees and expenses when you cash in on your investment. These front and back end costs will definitely reduce the rate of return.
After crunching all the numbers, you come to the conclusion that even after all costs have been figured into the equation this is a solid rate of return, you need to ask yourself the important question of “why.” Why is this investment giving me this rate of return? There are many possible answers to the question, but the most important reason for you to consider is how volatile the investment is. Volatility is simply defined as the historical performance of the investment over specific periods of time. If an investment showed a 10 percent gain 9 months ago, a 5 percent loss 6 months ago, and an 11 percent gain in the past 90 days, the volatility of this investment is high. The rule is: the higher the volatility, the riskier the investment – and the less dependable the rate of return is.
Finally, there is the tax man. After calculating costs and the volatility of the investment, you will eventually cash in your profits, and that is when the tax man cometh. There is a saying that if you walk away with only a $1 profit, it is still a profit and much better than a loss. That is not always true though. If you walk away with $1 and the tax man takes 95 cents of it, is there any real advantage to cashing in for a profit? The rate of return on investments usually fluctuates over the long term, so waiting to cash in even when the expected rate of return drops, can be an effective investment strategy. Always factor in taxes when calculating your rate of return.
This has been a condensed version of the steps you should go through when looking at an advertised or recommended rate of return on an investment. There are other considerations, but these simple steps will cover the majority of your investment decisions. Financial advertisements and prospectuses should come with the disclaimer “past performance is not an indicator of future results.” It is true, so be sure to take the time to get the information you need to make the best decisions.