What is a good investment return?

This was a question posed to me by a client recently. I was taken aback by the question as most clients (rightly or wrongly) tend to have fixed expectations about what a ‘good’ and ‘bad’ return is. It was an excellent question and I answered by saying that ‘good’ isn’t absolute; it is relative to the economic and financial environment in which we live.

For example, I remember walking into Cheltenham & Gloucester, Manchester in 1997 and opening a savings account and earning 7.5% per annum! Back then, the Bank of England base rate was 7.25%. If at the same time you were achieving a 7.5% pa return by investing in say, shares or gold, this would not be a ‘good’ rate of return because you would be taking much more risk to achieve the same return as that offered by the bank and only a few basis points above the base rate.

So, with the Bank of England interest rate currently sitting at 0.50% and the ECB base rate at a negative figure of -0.50%, a 4% or 5% pa return looks very attractive today, even though it would not have done in 1997.

Another factor we need to consider when assessing what a ‘good’ return means is the level of risk we take to achieve the return.

In constructing our portfolios at Spectrum, we always consider performance in the context of risk taken to achieve that return. For example, two funds can both achieve a 5% pa return but one fund may have fallen in value by 20% whereas another fund may be down just 5%. Clearly, the latter is a better fund.

We can analyse this in more detail by considering “scatter diagrams” which is an interesting way of looking beyond headline performance figures.

This type of chart shows performance on the vertical axis and compares this with volatility on the horizontal axis, which is a measure of risk.

Ideally, we want a fund that is in the top left of the chart i.e. it has very low risk and a very high return. Unfortunately, we know that we cannot have our cake and eat it and in the real world we have to take risk to achieve return, but the important thing that these types of charts highlight is if you are taking risk and not being rewarded for it.

For example in the above chart, fund B (purple square on the far right) is taking a high level of risk relative to the other funds as it is the furthest right on the horizontal axis and it is achieving a high level of performance as it sits high up on the vertical axis. Now, looking at fund A (aqua square second from the right), it has achieved a higher level of performance than fund B but has experienced much less volatility. It is clearly a superior fund, achieving higher performance with less risk.

The other factors we must also take into account when considering what a ‘good’ return means are the cost of running the investment and the impact of taxation.

Ensure you consider all costs when assessing whether you are getting a good return or not. Each fund manager will charge a percentage ongoing fee, but do not forget to factor in transaction costs on buying and selling investments.

Often more damaging is the taxation. Are you paying capital gains tax on each transaction as it occurs? Could you roll this up instead and benefit from compounding? Or are the tax implications impacting the decisions you make as an investor?

For example, a buy-to-let property that offers an attractive gross yield of 6% per annum looks like a good return on the surface, but once ongoing costs and tax are factored in, your net yield could be much lower, at around 2-3%.

Lastly, when comparing investments, you must always do a like-for-like comparison. So when you are benchmarking your investment ensure it is against its peers, for example, there is no point in comparing the gross return of your buy-to-let property against a BP stock you hold.