One of the biggest concerns of an investor is estimating the RoI, Return on Investment. Specially, when it comes to stocks/equity. 15%, 20%, 25% are the common numbers you hear. Working with such estimates is a recipe for disappointment and disaster. Let’s use a model to estimate our RoI, something that is grounded in logic and rationality.
Estimating RoI
A fixed income instrument such as Bank FD or PPF has an assured rate of return. A market linked investment such as stocks, there is none.
It is not easy to do so. Investors can rely on art, science and voodoo to figure out an estimated return on investment for their stocks or equity funds.
Well, I offer you a combination of the art (experience/wisdom) and science to help estimate a possible rate of return on your investment in the market.
Risk Premium
Fixed income instrument offers you an assured return as also promises a return of original investment. It is risk free. A PPF, PSU Bank FD or a Government Bond are examples.
In a market-linked investment, neither is assured. You are taking RISK. Now, you were better off with a Risk-free rate of return but you took the risk. What you want is a compensation for taking the risk.
Call it the risk premium, over and above the risk free rate. If you can earn 8% risk-free, the RoI for a risky investment has to be higher. How much higher is the question? In other words, what should be the risk premium?
A simple model to estimate RoI
Take a look at the image below. It is from the model I use for estimating RoI
The premise it works on is the same as described earlier. We can choose to invest in a risk-free investment or take risk by investing in stocks. If we are taking the risk, we need to be compensated with a risk premium.
In the model, I took the risk free rate as the 10 year Govt Bond Yield. It is fairly long term in nature and is backed by Government’s promise or the Sovereign Guarantee, as risk free as it can get. Currently around 7.5% annual.
In terms of risk premium, I have a simple and reasonable assumption. I need a 50% higher return (risk premium). I am okay with this compensation, though it can differ from investor to investor.
Å 50% risk premium translates into a 11.3% return from stocks. Now this is an average expected return, more like from an index fund.
Suppose I am not OK with this and expect to generate an alpha by using an actively managed multicap fund and/or my own stock portfolio. Let’s say that generates an extra 1% over the broad market return. The estimated RoI is 12.3%, in this case. Over a 10 year period, I would be really happy if this happens.
Want more? You can take more risk – mid caps, small caps, micro caps, private equity, etc. Accordingly, your demand for risk premium goes up.
The dynamics of investment returns
If you have come to accept this model then there is one more thing you need to accept. Investment returns are dynamic.
As the economy develops, inflation cools down and accordingly, the interest rates too. The risk-free 10 year Govt Bond yield will drop, to say 4%, after a couple of decades. In that scenario, your expectation of returns has to change too.
(There is a complex interplay between various macro factors including inflation, interest rates, GDP growth, etc.)
The estimated RoI in that case? See image below
So, that’s my way of thinking about RoI. Now, if you want to play around with the model, download the excel workbook. Of course, you can create one of your own too.
