"Forget the return ON my investment. What concerns me is the return OF my investment". Will Rogers (I think).
Return of vs Return on. This is probably one of the most misunderstood terms in investing and one of the biggest sources of argument between me and one of my very astute clients. It is best illustrated by an example. Suppose you make a loan of $100,000 to a friend with interest at 10% per year and the entire amount due in 10 years. If this is compounded annually he will owe you $259,374. If he comes to you at the end of 10 years and says I have managed to scrape up $100,000, its all I have and all I will ever get. I would say you got your money back. My client would say you have a big loss. I am not saying you made a good investment nor is your purchasing power preserved but you got your money back. Your return on investment was zero and your return of was 100%.
Let's recast this loan into one involving annual interest only payments at 10,000 per year. If we assume the friend comes to you at the end and says I have no money to pay your principal but at least you got your money back via the annual payments. Again, your return on investment was zero and your return of investment was 100%. These are relatively simplistic examples but they illustrate an important point. Remember I said your return on investment was zero and this was a poor investment but you put out 100,000 and you got back $100,000.
Let's Compare The Risk Levels. Which would you prefer? To go through 10 years and get your entire principal back or to receive $10,000 a year for 10 years and get no return at the end. From a total return standpoint, they are equal but if you think about it, the $10,000 a year scenario is far superior from a risk standpoint. This brings me to the key point of what I have been writing about for the past 5 years. The sooner you begin to get cash flow from your investment the lower your risk. Sitting on an investment for 10 years not knowing whether you will get what you have anticipated doesn't work. Especially for an investor in the later stages of life. Of course, I am aware that taking taxes into account, the conclusions are reversed but I still maintain that the lower risk of the cash flow scenario is worth a lower after-tax return.
Here is Another Scenario. Suppose in the last scenario, you have received $10,000 per year for 10 years and all you can collect at the end is $40,000. You have received a total of $140,000 and your return on investment calculates to be 5.30% compounded. So despite the fact that you only received 40% of your investment at the end, the interim cash flow more than makes up for this and your return is positive. Suppose this was a 20 year year loan and you received $10,000 per year for 20 years and $40,000 at the end. Your return is 8.80%. These bring me to two more conclusions. 1. When you receive interim cash flows from an investment, you really don't know whether they represent a return ON your investment or a return OF your investment until the investment is terminated. 2. The longer the investment continues and the more interim cash flows you receive, the less important the final payment becomes.
Do You Find This Boring? I wouldn't blame you if you did. That's part of the reason I seldom write about topics like this because, in my book, the biggest sin is boring. It's not boring to me. It's fascinating. The utility of these few points says a lot about planning your investment strategies. It's not just about getting the highest return possible on your investment, its about getting the type of return that meets your needs. If you are entering retirement, in a relatively low tax bracket, with an aversion to risk, it is far better to get the majority of your return in the form of interim cash flow (there are exceptions). If you are a high-tax bracket younger investor, you might want to have the majority of your investments in vehicles that allow you to build wealth with no interim tax consequences.
This Probably Leaves You With Questions. I would be happy to answer these via comments to this post or via e-mail or in person. Feel free to contact me at 303-902-3940. I will be in and out of town but should be back in Texas by mid October. I look forward to your comments.
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