When it comes to investing, there are an assortment of options to choose from. You could buy stocks, hold bonds, invest in alternative assets amongst a wide variety of others. Having so many choices can make it difficult to decide on the one that will likely produce the highest rate of return.
Some investments produce only capital gains, while others may both increase in value and generate cash flow. In addition, they may have different timelines for when you’ll sell – all of which adds to the confusion about which investment is right for you to choose!
So, how do you make an upfront apples-to-apples comparison between them to select the one that will likely have the best outcome based on your financial strategy?
To analyze your investment options before you buy, you need to understand the different expected rate of return calculations and how to use them. By doing so, you can determine which assets grow and compound the fastest, allowing you to achieve your financial goals sooner!
Here are 7 different rate of return calculations that will help you compare the potential success of your investment options based solely on yield. While this is helpful to a degree, it’s important to remember that risk, along with many other factors, are not considered in any of these metrics.
Before buying an asset, most investors would like to have a good idea of how it will perform and the yield they’ll receive. This information not only allows them to evaluate their options, but it helps them estimate when they’re likely to reach key financial milestones, too! (Like, retirement or financial freedom)
The expected rate of return calculation (aka projected rate of return) gets used to predict an investment’s performance based on the probability of future outcomes. It takes multiple scenarios into account and makes assumptions about the chances that each one has of happening. The results that have better odds of occurring are given more weight to the overall expected rate of return than the ones that are less likely.
The expected rate of return formula is:
Many investors use historical returns as a way to predict their expected rate of return, too. While this can be somewhat helpful, it’s important to remember that past performance is never an indication of future results.
Here are a few common assets and the expected rate of return on each, based on historical averages:
Some investors also use these expected rates of return as benchmarks. If they find an asset that will likely produce a return that’s higher than the ones above, they may decide it’s worth investing in it.
A nominal rate of return is one of the most basic investment return metrics. It allows you to quickly compare the projected financial gains of different assets, relative to their cost.
The nominal rate of return formula is:
This calculation shows your gains as a percentage of the amount you invested. While it’s a simple formula, it doesn’t consider other key factors, like taxes, time, or inflation which can all have a significant impact on the rate of return you actually receive!
A real rate of return takes the nominal rate one step further. It accounts for inflation, giving you a more accurate representation of your money’s future spending power.
The real rate of return formula is:
It’s important to calculate your expected real rate of return for all asset types, especially those that have a low yield. By doing so, you can determine if the money you’re going to invest in assets, like savings accounts, CDs, and bonds, will grow in real terms.
For example, imagine you’re thinking about buying a bond that has an expected rate of return of 2%. If inflation is projected to be 2% while you own it, then your purchasing power decreases by 1% and you end up with a net loss!
When it comes to creating wealth, the amount of money you make isn’t as important as the amount you keep. The same is true for investing and the after-tax rate of return factors in how much you’ll have left after paying taxes on your gains.
The after-tax rate of return formula is:
Each time you sell an asset that’s not held in a retirement account, you realize a capital gain and owe Uncle Sam. The amount you’ll pay gets determined by the type of income you received, your marginal tax bracket, and the amount of time you owned the asset.
For example, imagine you have the option of buying a corporate or a municipal bond. If each one pays the same nominal rate of 5%, how do you decide which one is a better deal?
With corporate bonds, you’ll likely pay capital gains tax, but on municipal bonds, you won’t. So, assuming each one has equal risk, the municipal bond has a higher after-tax rate of return and is, therefore, the better choice!
The previous rates of return calculations assume that you’ll buy an asset and sell it exactly one year later. But that’s rare and many times assets have different time horizons and projected holding periods.
The annual nominal rate of return calculation helps you compare investments by converting projected returns into a uniform holding period of one year. This allows you to compare options that have multi-year time horizons with ones that are much shorter.
The annual nominal rate of return formula is:
For instance, imagine you find an asset that has a 15% expected rate of return if you own it for 2 years. You also discover another one that pays 5% for owing it just 6 months, which one produces a higher yield?
The annual nominal rate of return on the first option is 7.5% (15% x .5) while the second is 10% (5% x 2), making it the higher-yielding asset!
But, just because it has a higher yield doesn’t mean it’s the best choice. Aside from risk, you should consider the odds of being able to re-invest these funds for a similar expected rate of return, too.
Many assets don’t perform in a linear nature. In some cases, they’re volatile and from one year to the next they can have large changes in price, making it hard to estimate your expected rate of return.
The compound annual growth rate (CAGR) smooths out price fluctuations, making investment returns linear and more clear. This allows you to compare them with other assets while taking the power of compounding into consideration.
The compound annual growth rate formula is:
To give an example. Suppose the expected rate of return on a stock is 30% in year one followed by -25% in year two. How does this stock compare to a high yield savings account that pays .5% in annual interest?
Using a compound annual growth rate calculator, you find the stock has a CAGR of -1.26% while the savings account is 0.5%. Given the choice between these two, it’s a better money move to fund the savings account!
Not all assets produce capital gains, solely. Some generate cash flow, too.
Typically, when you buy real estate or a business, you’re required to invest a large amount of money upfront. Over time, these assets can produce cash flow and will get sold at some point in the future.
The internal rate of return calculation (IRR) shows an investment’s annual growth rate based on its expected cash flows.
As an example, imagine you find a rental property for $100k and it requires a $25k down payment. You estimate it will take one year and $10k to get it ready to rent. After which, you expect to have a $3,000 cash flow in Year 2 and $3,300 in Year 3. At the end of Year 3, you expect to sell the property for $130k. Is this a smart investment?
To find out, you’d need to put all of this information into an IRR calculator, like so:
Pressing the calculate button reveals that the IRR is over 20%, likely making this investment one of the best uses of your money!
It’s important to point out that an IRR isn’t completely foolproof. It assumes that you can immediately reinvest all cash flows into the project at the IRR, which in most instances can’t happen.
Still, the internal rate of return calculation can be a good rule of thumb to help you make better investment decisions. Generally, if it’s higher than your cost of capital or the interest rate on your loan, then the investment will likely be profitable.
When considering your investment options, calculate the expected rate of return on each one before you buy. Not only will this confirm that a portion of your investment criteria get met, but that you’ll likely receive the highest yield, too!
While earning a high rate of return is important, it’s just one aspect of investing. Depending on your investment strategy, age, and money personality; it may not even be an essential part of your plan, either!
Still, you need to research, perform due diligence, and be comfortable with the risks you’re taking before you buy any asset. Otherwise, you’re not only jeopardizing your financial wellbeing but your future, too!
Which expected rate of return calculations do you perform before you invest? Comment below.
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