What is an acceptable rate of return (2)

Back in April 2006 when I started this blog, one of the first questions I asked was "What is an acceptable rate of return?" Nearly two years later, it's still a question that I keep coming back to. Obviously, higher rates of return are better than lower rates of return. Equally obviously, if a higher rate of return is only achieved at the cost of being exposed to higher levels of risk, then it has to be asked whether the additional return is justified?

The problem can be approached from two different directions:

1. what rate of return is needed to achieve a given financial objective?

2. what rate of return is it reasonable to expect from a given asset or asset class over a given period of time?

Assuming that the answer to question #1 is a sensible one, the answers to question #2 can be used to construct a portfolio of investments that should both individually and collectively have a reasonable expectation of achieving the desired rate of return (preferably with a margin for error).

As an example, in November 2007 calculated that my investments had to return about 6.7% pa (net) in order to retire in about five years from now. Accordingly, I should be looking to invest in assets that can be expected to show average rates of return of at least 6.7% pa over a five year time period. The main asset classes available to retail investors are:

1. equities. Recent months have seen equities taking a beating and sentiment is currently very negative. Although valuations are much more reasonable now than in the middle of 2007, they are not at bargain levels. That said, long run returns on equities have traditionally been in the range of 8-12% pa (depending on which market you are looking at). Even the lower figure gives an adequate margin for safety. The key issue is to make sure that the return does not get eroded through transaction costs, management fees and other avoidable expenses;

2. real estate. Hong Kong real estate has driven the returns on my portfolio over the last four years. I do not expect those rates of return to continue. However, a reasonable expectation for ungeared property is a total return equal to net yield + the rate of inflation. This would currently be about 7-8% pa. Again, this gives me a margin for safety. The key issues are transaction costs, vacancies and longer term maintenance etc. Buying needs to be very disciplined to ensure that only purchases that adequately allow for these factors are made;

3. bonds. The best I will do on a HK$ bond with a high credit rating is about 3%. This is below both the required rate of return and below the rate of inflation. I cannot see any justification for holding bonds;

4. cash/deposits. HK$ deposits pay negligible amounts in interest. Every dollar sitting in the bank is a dollar that is not only losing money but dragging down the rate of return on my portfolio as a whole. This is not to suggest that putting money on deposit in the short term is a bad decision. It may take a while to identify suitable investments or you may take the view that equity markets will decline further. In those situations, holding money on deposit makes sense. The point is that in the longer term, cash and deposits are a losing investment;

5. foreign currencies. Several currencies have shown rates of appreciation (+ interest) well above the required rate of return. This is one way to achieve diversification. The decline of the the US$ has been a significant contributor to returns on my portfolio over the last 12 months or so;

6. commodities. Today's hot sector. So far, my limited investments in commodities have shown rates of return well above the required rate of return. As I am much less familiar with commodities as an asset class than items #1-5 above and I wish to keep my exposure limited until I have a much better understanding of commodity markets. The one thing I do understand is that they have historically been highly cyclical investments. This means that unlike (for example) an equity fund which could be held forever, it is unlikely that commodities should be simply held and forgotten.

Actually, I need to look well beyond a five year time horizon as the same assets will need to support us through our retirement. For the purposes of asset allocation, this longer time horizon is actually helpful as reduces the risk of short term volatility forcing me to adopt a sub optimal asset allocation strategy.