Frugal Fridays: Return on Investment

Welcome to Frugal Fridays where we share money saving tips, discuss living frugally and generally talk about personal finance issues.  Last week at lunch on Saturday, my friends and I were having a discussion about different types of investment and retirement accounts and how to decide where to put your savings to maximize your long term return.  (As an aside, yes, I know we are all nerds, no need to point that out in the comments.)  Anyhow, we are all pretty bright people, and yet we found we sometimes had trouble predicting what would be the expected rate of return under different circumstances.  Which got me thinking about how computing rate of return can be a really difficult calculation to make sometimes.  I want to take a stab at clearing up some of the confusion around this topic, today.  In the end, however, I may be as confused about this as anyone, so if you see something I say that you disagree with, please don't hesitate to point it out in the comments.

Disclaimer: I am not a financial professional.  I'm just a consumer who tries to be educated.  Take anything I say with a grain of salt.  

Before I dive into the details, I want to make it clear that return should not be the only factor you consider when choosing your investments.  Other factors, such as risk and liquidity, can be equally important to consider.  In addition, there are costs and benefits that may be not monetary, such as societal or environmental concerns.  Don't forget to factor in the value of your time.  How you weight each of these factors is a personal decision.

Return on Investment (ROI)
The basic formula for calculating annual ROI for a one year investment is very simple:

ROI = (Final Payoff - Initial Investment) / (Initial Investment) * 100

What could be simpler, right?  There are only two terms in this equation.  The devil is in the details of how to compute each of these terms.  If you are talking about a one time investment and a one time payoff, which you are taxed on immediately, it is relatively straightforward but anything more complicated than that can get tricky.

If your Initial Investment is made over time, rather than all in one initial lump, you need to pro-rate your investment to account for that.  Similarly, if your Final Payoff is made over time, such as in the form of dividend payments from a mutual fund, you need to account for that as well.  Even more complicated is a situation where you get both payments over time and some capital gain at the end of the term.

Compounding and the "Rule of 72"
The above formula computes simple interest for a single year.    It doesn't take into account the effect of compounding your interest over multiple years.  Compounding has the effect of increasing your effective rate of return.  If you put money into a savings account at 6% interest for 12 years, your total rate of return is not 72% (6 * 12) but rather almost exactly 100%.  This is a simple illustration of both the power of compounding and the "Rule of 72"  If you are trying to figure out how long it will take to double your money with an investment whose rate of return fluctuates from year to year, a good rule of thumb is that your initial investment will double when the sum of the annual returns you receive reaches 72.  For example, if you earn 8% for the first 5 years, then 4% for the next 3 years and then 10% for the next 2 years your investment will have doubled in those 10 years (8*5 + 4*3 + 2* 10 = 72).  This rule of thumb is less accurate for very high or very low interest rates, but it is useful as a first order approximation of your long term rate of return.

Fees and Other Costs
You need to deduct any fees or other incidental costs you have to make this investment from your Final Payoff amount.  Some of these fees are obvious, such as account maintenance fees or brokers sales commissions, but some are less obvious and some are really hard to put a dollar value on.  Back in the 90s, when day trading was popular, some people rented office space with special computer hardware and software.  All those expenses need to be factored in when computing their return.  That's probably a really bad example, since my understanding is that most of those people ended up with a negative return anyway, but you get the idea.

Taxes
The above discussion has all been concerned with computing pre-tax ROI on your investments, but in actuality, your tax obligation will change your effective rate of return.  To compute the after-tax ROI, subtract the tax you owe from your Final Payoff amount.

Unfortunately, this calculation is much easier said than done, particularly when you are talking about predicting future taxes on investments you have yet to make.  Some very smart people spend their entire careers examining this issue and trying to find optimal solutions for individuals so I am not going to by any means be able to cover this exhaustively here.  I just want to throw out a few ideas for your consideration.  Keep in mind that tax laws are constantly changing.  If you are trying to predict what the tax consequences will be on some investment gain you realize in the future, there are no guarantees the laws won't change between now and then.

• Currently, long term capital gain rates are lower than ordinary income rates, so it may make sense to try to invest in instruments that will produce long term capital gains rather than short term dividends or interest payments.
• Roth accounts (both 401Ks and IRAs) allow you to grow your investments tax free.  This lets the power of compounding work for you in ways that it can't in accounts where the gains are taxed when you realize them.
• Standard IRA and 401K accounts afford you a tax deduction when you initially make your deposit.  This has the effect of increasing your initial investment at no cost to you.  In addition, your gains are not taxed in these accounts, which may allow them to grow more quickly than in taxed accounts. However, all your withdrawals from these accounts (both gains and original investment) will be taxed at your ordinary income tax rate when you make them.  Quite possibly that rate will be lower than your current tax rate, so in the long run these accounts will be beneficial for most people, but not for everybody.
• The interest that you pay on your home mortgage is, unlike interest that you pay on other loans, tax deductible.  Paying  your mortgage off early may not be the best way to invest your extra cash, particularly if you itemize your deductions on your tax return.

Further Resources
If you want to read even more, here are some good resources I've found:

• BankRate has good advice articles, calculators for various financial purposes and is also a great source for finding banks that offer the best investment return rates for IRAs, CDs, Money Market Accounts, and other types of accounts.
• Investopedia is another site with a very good glossary where you find the definition of many other confusing terms you may encounter and advice articls.
• Dinkytown has a ton of financial calculators for almost every conceivable scenario.

Frugal Tip of the Week: Have you ever lost a camera or memory card with pictures?  Have you ever found someone else's?  If the answer to either of these is yes, go look at I Found Your Camera which tries to reunite lost photos with their owners.  

Upcoming Frugal Fridays
There will be guest authors and other changes to Frugal Fridays in the upcoming weeks.  Here's what you have to look forward to:
April 4: I'll be guest hosting a combined Frugal Friday/Mojo Friday diary as a standin for TexDem.  Look for it at 7:30 am PDT
April 11: plf515 will be guest hosting here and his regular Friday diary, What Are You Reading?, will be guest hosted by someone else
April 18: business as usual
April 25: AnnieJo will be guest hosting Frugal Fridays
May 2: blue jersey mom will be guest hosting Frugal Fridays
May 9: back to business as usual, at least for a while

If you are interested in writing a diary for this series, or you have a topic you'd like to see covered, or if you want to be added to the mailing list for announcing these diaries, email me: frugalfridays (at) gmail.com.