In a return-chasing investment world, how much return is too much return? There is no one answer. But, if you are a sensible investor, there is a system to build return expectations. It won’t let you go overboard on return expectations. Simple, yet not many investors resort to it.
How to build return expectations
Risk-free return + inflation + risk appetite – taxes = Expected returns
While chasing returns is futile, you must have a fair idea of how much you may earn from an investment product. This return expectation should be logical – not built on whims and fancies. What logic? First, try to find out the risk-free return in the country. This is the rate at which the government issues government securities. Alternatively, you may track the ongoing fixed deposit rates. Next comes the inflation. The investments you make should beat inflation, so the total returns on your preferred investment should be enough to beat inflation and at the same time grow your money. For example, if the risk-free rate in the country is 6 per cent and inflation 7 per cent, then you must earn more than the risk-free and inflation rates combined. The targeted returns should always factor in taxes. The return expectations should always be in post-tax forms.
“The average rate of inflation in India has been around 6%. To preserve the value of your investment, your portfolio should generate at least a 6% CAGR after tax. At this rate, you will double your money in 12 years and your purchasing power will remain the same,” says Pratik Bagaria, Vice President - Investments at dezerv.
“A well-managed aggressive portfolio should generate a 15% CAGR after tax. At this rate, you will double your money in 5 years and your purchasing power will increase by 1.5 times,” he adds.
Now comes the most important part. Your risk appetite. Any return that you seek above the risk-free rate shows your risk appetite. The higher the returns over risk-free rate you expect, the higher your risk appetite must be. For example, those investing in the stock market have a higher risk appetite. They target at least 12-15 per cent returns from the stock market. This is just double the risk-free rate in the country at 5-6%. Those investing in cryptocurrencies hold even higher risk appetite. Their return expectations could be upwards of 20 per cent.
“While generating a higher return is possible, it will require you to take disproportionate risks. Hence, depending on your risk profile, you must target between 6% to 15% CAGR after tax at a portfolio level,” says Bagaria.
Bagaria also highlights the importance of market factors. For example, in case of equities, valuations have a role to play in return expectations. Price-to-equity ratio shows the valuation. “When the Nifty50 PE ratio is between 10x to 15x the average 5-year return is 29%, and when the PE ratio is between 25x to 30x the average return is 5%. If you are investing when market factors are favourable, you can expect a higher return,” he says.
In a nutshell, one should target beating inflation in return expectations for sure. The rest depends on the investment product you choose, debt, equity, gold or real estate. The product selection should be such that it aligns your return expectations with your risk appetite. Finally, stay invested as per the minimum time horizon suggested for a product. “Sometimes investors forget that to generate wealth, return is not the only variable. Investing regularly and staying invested for a long period of time are also equally important to reach their desired goals,” says Bagaria.