Tuesday, 16 December 2008

What is your optimum Return on Investment?

Your Money: What is your optimum ROI?

By : Yap Ming Hui

RETURN on Investment (ROI) is an important ally in attaining financial freedom. ROI can help us overcome the threat of excessive spending and inflation. If we are serious about achieving our own financial freedom, it is important for us to understand and know ROI better.

Power of compound ROI

Table 1 shows the compounding effect of RM100,000 invested at different compound ROI compounded over 36 years. From the table, we see that differences in ROI that may appear moderate in the short-term can, with compounding, multiply into very large differences in the long term.

For example, if you don't do anything with your saving which earns about two per cent ROI then. your RM100,000 will multiply by two times to RM204,000 after 36 years. If you transfer the money into fixed deposit, you may earn about four per cent ROI and multiply your RM100,000 by four times to about RM410,000. If you grow your money at eight per cent ROI your RM100,000 will multiply by 16 times to about RM1,597,000. With a slight increase of your ROI from two to eight per cent, you end up having a huge difference of RM1,393,000. (1,597,000 - 204,000). If you grow your money at 15 per cent ROI, your RM100,000 will multiply by 153 times to about RM15,315,000. Of course, increasing the ROI means you may face higher risk of losing your money.

The price of making a mistake

Most people fail to realise the high rate of ROI required to make up for money lost in investment. For example, if you start with RM100 and lose 50 per cent of it, you would have to earn 100 per cent on the remaining RM50 just to get back to where you were at the beginning.

Table 2 shows the ROI required to overcome various losses. The time period is five years, and there are two scenarios: an ROI target of 10 per cent and of 15 per cent.

For example, you plan to increase your money for the next five years with 10 per cent ROI. Unfortunately, instead of getting 10 per cent target return, you ended up with a 25 per cent loss. In order for you to still achieve your original target, you would need to achieve 21 per cent ROI for your money for the next four consecutive years. Now, that's the price you will have to pay for making 25 per cent loss in first year.

Do you think it is easy to achieve 21 per cent for four years continuously? Of course, it is not easy. In addition, you will also notice the spread between the amount of the loss and the required ROI over the next 4 years widens as the magnitude of the loss is increased. The larger the losses, the more difficult it is to overcome. I believe you now understand why the first rule to investing, according to Warren Buffett, is "Never lose your money".

Inflation-adjusted ROI

Our money is subjected to the depletion of inflation. Therefore, to effectively grow our money, we need to attain an ROI higher than the inflation rate.

For example, if the inflation rate is four per cent, the 3.7 per cent interest rate for your fixed deposit will not help your money grow. In fact, in the long run, you lose your money safely. In this case, the inflation-adjusted ROI is actually -0.3 per cent (3.7-4).

Therefore,to grow our money, we need to seek inflation-adjusted ROI.

To achieve financial freedom, you have know what rate of ROI you actually need.There is an optimum ROI rate to target and achieve. This optimum ROI rate should be higher than the inflation rate but not too high that will risk losing money.

Therefore, the challenge for all of us who want to achieve financial freedom is to find out what that ROI is? Do you know what is your optimum ROI? If not, it is always better to find out earlier than later.

Yap Ming Hui is the managing director of Whitman Independent Advisors Sdn Bhd, the first multi-client family office in Malaysia.


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