How To Calculate Return Of Your Investment?

Berkshire Hathaway defines the investing as "the transfer to others of purchasing power now with the reasonable expectation of receiving more purchasing power - after taxes have been paid on nominal gains - in the future". Using purchasing power in the definition of investing makes a lot more sense than using only the amount of money because of the inflation.
Based on that definition here is the equation on how you should calculate your return on investment approximately when you invest on common stocks. (The equation can be used for all types of investments with minor modifications.)

Investment return = (capital gain + dividend) - tax - (bank interest if you save the money in a bank or government bond interest if you invest on the bond) - inflation cost.

Note:

• You have to deduct the tax you need to pay.
• The reason that bank interest (or bond interest) should be considered here is you will get some bank interest if you simply save the money in your bank account.
• Inflation cost = your initial principle money * inflation rate. For example, if your initial money is $100, inflation rate is 4.2%, then the inflation cost is $100*4.2% = $4.2.

Let's look at 3 examples.

Example 1:

• Your initial principal money is $100.
• You earned 3% on capital gain and 3.5% on dividend, therefore you gross return is $100*(3%+3.5%) = $6.5.
• Suppose your tax rate is 20%, and your tax is $6.5*20% = $1.3.
• Suppose bank interest rate is 1.5%, your bank interest would be $100*1.5% = $1.5 if you save your money in a bank.
• Suppose inflation rate is 4.2%. The inflation cost is $100*4.2% = $4.2.
• Your investment return = $7.5 - $1.3 - $1.5 - $4.2 = $0.5
• Your investment return rate $0.5/$100 = 0.5%

Note: even if you seem to earn 6.5% (3+3.5), your real effective investment return rate is finally 0.5% from the earning power point of view. The interesting thing here is, even if you earn, let's say 3% capital gain and 2.5% dividend, you will end up with -0.05% return. ($6.5 - $1.3 - $1.5 - $4.2 = -$0.5)

Example 2:

• Your initial principal money is $100. Let's say you save your money in a bank to get some interest as investment.
• You earned 0% on capital gain and 0% on dividend, therefore you gross return is $0.
• Suppose bank interest rate is 1.5%, your bank interest would be $100*1.5% = $1.5 if you save your money in a bank. This time your bank interest should be consider as your income and will be added instead of being extracted.
• Your tax rate is 20%, and your tax is $1.5(bank interest)*20% = $0.3.
• Suppose inflation rate is 4.2%. The inflation cost is $100*4.2% = $4.2.
• Your investment return = $0 - $0.3 + $1.5 - $4.2 = -$3.0
• Your investment return rate -$0.0/$100 = -3.0%

Note: keeping your money as cash in long term is far from a good choice. The inflation will eat your money up piece by piece.

Example 3:

• Your initial principal money is $100. You have a profitable business and you invest your money in your business. This example will be more understandable to a business man.
• The average American business needs $5 to earn $1 profit (20%). Let's suppose you have an average business. You earned 20% on the investment capital of $100, which is $20. If your business involves little debt, you can consider the investment capital as equity. The return on equity is 20% in your case.
• Your corporate tax rate is 35%, and your tax is $20*35% = $7.0.
• Suppose bank interest rate is 1.5%, your bank interest would be $100*1.5% = $1.5 if you save your money in a bank.
• Suppose inflation rate is 4.2%. The inflation cost is $100*4.2% = $4.2.
• Your investment return = $20 - $7.0 - $1.5 - $4.2 = $7.3
• Your investment return rate $7.3/$100 = 7.3%

Note: your real effective investment return rate from your business is 7.3% from the earning power point of view. If you have a profitable business, even an average business, your money is automatically protected from inflation. That is also one of the reasons why many business owners become richer and richer even if the inflation rate is there for all the years.

In investment inflation is always an important factor.

Why Investing In Common Stocks?

Negative Side

• Based on the US CPI Inflation data, the purchasing power of 1 dollar in 1965 becomes 1/7.14 = 0.14 dollar in 2011.
• That means the US dollar has fallen 86% during that period.
• The average annual inflation rate is about 4.2% from 1965 to 2011.
• (1-4.2%) ^ 46 = 14%
• Under the US government Expansionary Monetary Policy, the inflation will continues into the future, and some of the years it will become out of control (like in year 1980)
• The inflation will eat up, in high living costs, your income, and your cash.
• Here is the official inflation calculator.

http://www.bls.gov/data/inflation_calculator.htm

 

To protect your money from inflation, you have a variety of options.

• Precious metals (gold and silver), diamonds, paintings by masters, rare stamps and coins, etc. This is not a good option. You should avoid this type of non-productive investment.
• Government bonds or high grade corporate bonds. These will partially protect you from inflation. This is a better-than-nothing option, but far from the best option.
• Real estate. Usually this will at least protect you from inflation. If you buy the real estate in an economic depression period, you will do pretty well. The risk is, if you pay too much on an overvalued real estate, you will be in losing-money status and have to wait for a long time to become profitable. In addition, your borrowing capacity sometimes limits your investment ability in this area.
• You are doing business. If your business is stably profitable your money will be protected automatically. The risk is your business may lose money or even get bankrupt.
• Common stocks. This is the best option. The risk is you may end up losing money if you don't have the necessary common stock investment knowledge (even if you think you have). But with some basic investment methodology, you can do very well in this option.

Positive Side

• You can make a decent return from investing on common stocks.
• In the last century from year 1900 to 2000, the Dow Jones Industrial Average (DJIA) rise from 66 to 11497. The average annual return is 5.3%. In addition, the average dividend yield rate from the DJIA is above 3.8%.
• From the following chart you can roughly find out the average DJIA dividend yield rate.

• If your income tax rate is 20% for the dividend, then you will get 3.8% * (1-20%) = 3.04% after-tax return on the dividend. Tax on dividend needs to be paid every year.
• If you invest in DJIA for the last century, your annual return is 5.3%+3.04% = 8.34%. Your total return for the century will be (1+0.0834)^100 = 301220%.
• That means, if you invest $100 in year 1900 on DJIA, you will end up with $301,220 in year 2000. If you don't invest you will simple end up with $100.
• If you can have a solid methodology to get a little better result than DJIA then you can earn a lot more money than the $301,200 because of the compound accumulation. The following are the tables that compare the results of annual return of 10%, 12%, 15% for periods of 100 years and 30 years. (Long term investment can avoid much of income tax as you don't need to sell stocks every year and therefore you don't need to pay taxes every year. For simplicity purpose, we ignore the income tax factor here.)

Investment During: 100 Year
Annual Return	Total Return	Beginning Amount	End Amount
(DJIA)8.34%	1.0834^100 = 301,220%	$100	$301,220
10%	1.10^100 = 1,378,061%	$100	$1,378,061
12%	1.12^100 = 8,352,227%	$100	$8,352,227
15%	1.15^100 = 117,431,345%	$100	$117,431,345
20%	1.20^100 = 8,281,797,452%	$100	$8,281,797,452

Investment During: 30 Year
Annual Return	Total Return	Beginning Amount	End Amount
(DJIA)8.34%	1.0834^30 = 1,106%	$100	$1,106
10%	1.10^30 = 1,745%	$100	$1,745
12%	1.12^30 = 2,996%	$100	$2,996
15%	1.15^30 = 6,621%	$100	$6,621
20%	1.20^30 = 23,737%	$100	$23,737

I will talk about more on how to invest on common stocks later.