What Does "Rate of Return" Mean to you?

Rate of Return...Crystal Ball?

When you hear people talk about stocks, mutuals, and the market they refer to the Rate Of Return (ROI) as a measure of performance. Do you know what it truley means? Or how it translates to your portfolio and thus your future retirement? Can ROI be used as a crystal ball and tell you what you are in store for?

ROI Defined

The simple definition is the ratio of money gained or lost on an investment relative to the amount of money invested. I think of ROI as a percentage that reflects profit/loss or dollar change in a portfolio over a defined period of time.

Breaking ROI Down

Let us imagine that you have 200,000 dollars in a balanced mutual fund(s) account and your Q4 statement says that you earned 12% for the year 2007. Is this good or bad? Many advisors would say this is great! That your mutual fund matched the growth of the S&P 500. Well lets break down the ROI number shall we. The return of 12% is not taking into account inflation. The inflation rate has been around 3% for several years and is a good number to use as a base value. However, I am conservative and like to use a 4% inflation rate.

Why include Inflation?

First, the definition of inflation. Inflation is measured as the growth of the money supply in an economy, without a commensurate increase in the supply of goods and services. This results in a rise in the general price level as measured against a standard level of purchasing power. In simple terms...its the explanation of why the price of milk in 1980 increased from 1.50 a gallon to 3.25 today. This perspective is important in terms to future dollars. In order to have an accurate picture of your finances you need to account for the rate of inflation...or the loss of purchasing power that todays dollars will have in the future.

Now lets return to our example, including inflation in your 12% ROI...12% subtract 4% equals 8% (I call this Rate of Real Return or RRR). This is not bad...or is it? To fully appreciate this we need to put this in terms of how long we have until planed retirement? Lets say that you have 20 years left till retirement...what will your 200,000 dollars grow to at an average 8% RRR?

Learn the Rule of 72

The rule of 72 states that if you take your RRR and divide it by 72. This number equals the estimated years it will take for your account to double. Lets apply this to our example portfolio: 8% RRR divided by 72 equals 9...9 divided by 20 (years till retirement) is 2.22 rounded to 2. This means that the 200,000 dollars portfolio will double twice at an 8% RRR. Or be valued at 800,000 real dollars at least the estimated purchasing power of your account in 2030 the retirment date for our example.

Is this good or bad?

This depends on the individual...If you feel comfortable with a retirement account of 800k then you are doing great...if not, at least you have an additional 20 years to build your account to the appropriat levels. ROI may not be a crystal ball...but with applying proper applications like RRR or the Rule of 72 we can get pretty close.