Setting A Required Rate of Return

We all know low risk is associated with low returns and high risk high potential returns. It is important to set expectations proper. It is ludicrous to expect 10% returns on your 6month fixed deposits.Plus there are different expectations for different asset classes. So how does a person set a required rate of return and are there methods to do just that? Returns are such an important consideration out of 7 others. First and foremost, this write up is just but 1 method of setting rate of return expectations. This method has been taught in CFA curriculum and my personal method of choice because of its simplicity and the heuristic RDMILT is easy to recall while scribbling away at the CFA level 3 exams. This method is called the risk premium approach, slap on the relevant risk premiums in deciding the required rate of return.

Risk Free Rate

Before the Singapore Savings Bonds came along, most would use the US 10year Treasury Yields as the benchmark. I just gave away a secret, didn’t I? So a fair proxy for the local risk free rate here in Singapore is in the range of 2-2.5%.

Default Risk

What in the world is that? How does one measure this? Is this even applicable? Default risk is the chance that companies or individuals will be unable to make the required payments on their debt obligations. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. To mitigate the impact of default risk, lenders often charge rates of return that correspond the debtor’s level of default risk. A higher level of risk leads to a higher required return.(Taken from Investopedia) One convenient proxy is the difference in yields between the corporate bond and a government bond of the same tenure. Is it applicable for all situations? No. It’s more so in fixed income and if it is not relevant, no need to factor that in.

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Maturity Risk

Notice that a 1year fixed deposit pays more than a 3month fixed deposit? That is the concept. Earlier I spoke about the yield curve, different yields are plotted along the different tenures. So if you want to be compensated for holding a 5year security for another 3years, take the yield difference between 8yr and 5yr point plots.

Inflation Risk

That cup of coffee used to cost $0.80 and now it costs $1. You can check the MAS (Monetary Authority of Singapore) website for inflation data and don’t be surprised that varies from different time period measurements. Anyway 2-3% can’t be far off.

Liquidity Risk

It is the bid-ask spread as a percentage of the price. For highly marketable securities with tight spreads, it is negligible. Where in cases of low transaction volumes and stale pricing (last transaction done probably a year ago) with bid-ask spreads wide enough for a car to go through, yes buyers and sellers face off to see who flitches. If you are not in a fire sell mode, you definitely want to be compensated on exiting the investment. Generally speaking, it is easy to get into an investment but hard to get out profitably at the timing you want.

Taxes

It is been said that only 2 things in life are for certain, death and taxes. So where capital gains tax or any form of taxation is applicable to the investment instrument, factor it in to be compensated in your required rate of return.

There you have it, RDMILT. Not all of it is applicable, but let’s just say the risk free rate and inflation alone, 2%+2%=4%. Wait a minute, that is the CPF Special Account rate currently right? Hmmm…

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