Required Rate of Return: The Building-Block Approach

Lower risk generally goes with lower returns, and higher risk with a wider range of possible outcomes, good and bad. Different asset classes come with different ranges, so it makes sense to set your requirements before you invest rather than after.

A required rate of return is the return an investment would need to earn to be worth holding, given its risks. It is a hurdle you set for yourself, a planning assumption. It is not a projection or a promise of what any investment will earn. Nothing here says any investment will reach it.

The building-block approach

There is more than one way to set a required rate of return. This is the one I learned in the CFA curriculum, and my method of choice because it is simple. It is called the risk premium approach: start with a base and add a premium for each risk you take on. The building blocks spell RDMILT.

R: the base rate

Start from the yield on government securities of a similar term, such as Singapore Government Securities. That is the return available for lending to the government, and every other block is added on top of it.

D: default risk

Default risk is the chance that a borrower cannot make the payments it owes. Lenders charge more to borrowers who are more likely to default. One common way to gauge it is the difference in yield between a corporate bond and a government bond of the same term. It mainly applies to fixed income; where it does not apply, leave it out.

M: maturity risk

A ten-year government bond usually yields more than a one-year bill. That is the maturity premium: compensation for committing your money for longer. Comparing the yields at different terms on the yield curve shows how much extra a longer commitment is paying.

I: inflation risk

A cup of coffee costs more than it did ten years ago. Money that is not keeping pace with prices is losing ground, so inflation is part of the hurdle. The Monetary Authority of Singapore publishes inflation data, and the figure depends on the period you measure.

L: liquidity risk

Liquidity risk shows up in the gap between what buyers bid and what sellers ask. For heavily traded securities the gap is small. For thinly traded ones, where the last trade may have been months ago, it can be wide, and getting out at the time you want can be hard. If you might need to sell, ask to be compensated for that.

T: taxes

Where tax applies to an instrument, factor it in, so the hurdle is what you need after tax.

Putting it together

Not every block applies to every investment. A government bond held to maturity needs little more than the base rate and inflation; a thinly traded corporate bond needs most of the blocks. Add up the ones that apply and you have your hurdle. The same thinking works for money held in a scheme such as the SRS, where idle cash is a choice too.

The useful part is the comparison. If an investment needs optimistic assumptions to clear your hurdle, that is worth knowing before you commit. It is also worth asking how much of your portfolio you could afford to see go wrong, which is the subject of Hero or zero.

Return is also one of seven considerations for any investment, and rarely the whole story. When options differ on several factors at once, the FDM method lets you weigh return against everything else on paper.

Questions

How do you calculate a required rate of return?

Add the building blocks: start with the base rate, the yield on government securities, then add a premium for default risk, maturity risk, inflation risk and liquidity risk, and allow for tax. The total is the hurdle a holding needs to clear to be worth its risks to you.

Is the required rate of return what I will earn?

No. It is a planning assumption you set. An investment can fall short of it, and the value of any investment can fall as well as rise.

First published on isaacfang.com on 16 August 2018. All rate figures and the closing CPF example have been removed so the piece does not date; the method is unchanged. Lightly edited for this site.