You want to grow your money. Who doesn’t? The necessary condition to grow your money is that you must earn a positive Return on Investment (ROI). A positive ROI means the surplus that you generate over and above your initial investment. Like when Joe puts 10,000 dollars in one year certificate of deposit (CD), at the rate of 6%, per annum, with a private money lender, and earns 600 dollars as interest, at the end of the year, over and above his deposit; his ROI is 6%.
From his interest earnings, he will pay IRS, at a rate of income tax applicable to him. If the rate of income tax applicable to him is 28%, he will pay tax at the rate of 28% of his interest earnings, that is 168 dollar. His ROI, net of tax, then is 4.32%. If the inflation is 4.32%, he is earning zero ROI, in real terms. What if inflation is more than 4.32%? Now he is having negative ROI, in real terms.
That is one black eye.
Think for a moment that the private money lender defaults on repayment of principal with interest at the end of the year, and Joe recovers only 9200 dollars, net cost of recovery, in the settlement; his ROI is now negative 8%. He has lost 800 dollars of his initial investment of 10,000 dollars. If he could write off his capital loss of 800 dollars and save 28% tax by writing it off, his effective loss is 576 dollars or say effective negative ROI of 5.76%. The opportunity missed (loss), if added, will make it still higher.
That is two black eyes.
From this simple scenario, we may note that there are actually two ROIs, that concern Joe. One ROI is Return on Investment. The second ROI is Return of Investment.
While first ROI, that is the return on investment, is so often talked in the financial markets, the second ROI, that is return of investment, remains the responsibility and part of due diligence of the investor. Fiduciary responsibility notwithstanding, let the buyer beware remains the standard practice in the market.
Though both ROIs are of as much concern to institutional and wealthy investors as small investors, but small investors must have an extra concern for return of investment, as they play with their own money and have limited risk-taking capacity. The concern for Return on Investment is also commonly known as concern for Return; and concern for Return of Investment is known as concern for Safety. Return signifies growth of initial investment. Safety signifies safety of initial investment.
In addition to Return and Safety, there is one more dimension to investment decisions, that is liquidity. Liquidity signifies ability to convert initial investment into cash or withdraw money at will. The best investment would be thus one that offers a good combination of return, safety and liquidity.
Truthfully, that is a ‘wonder’ investment. The reason is simple. The three dimensions of an investment of return, safety and liquidity present a perfect dilemma, in the sense, that when two axis come closer, the third moves away.
For example, when safety and liquidity are provided, the return becomes low. Bank deposits are the case in point. When return and liquidity are provided, the safety is low. Stocks are the best case in point. When return and safety are provided, the liquidity is low. The investment-grade bonds are the case in point.
In conclusion, in order to sustainably grow your money, prioritize your investment objectives. For individual or retail investors, in my opinion, safety, that is return of Investment, should be the top priority. If you could combine safety with positive return on Investment, net of tax and inflation, sacrificing liquidity for a short term, that is, up to 12 months, you have found it; if not wonder, a nearly wonder investment. Are there any such nearly wonder investments available in the market? The answer is yes!
Dr Sat Parashar, PhD, is a Professor and Financial Advisor. He is former Director of IIM, Indore. He may be reached at sparashar@financialguide.com
