Set the right yardstick for your financial plans

Everyone likes a positive return on their investment, there is no exception. The question really is how much returns. The basic yardstick is the gross return which is basically the returns on investments irregardless of time. You invest $100 10 years ago and the investment is worth $150 today, the gross returns is 50%. Simple.

It is important however remember that the purpose of investment is to accumulate a certain wealth over a specific period of TIME. With gross returns, it is easy for you to wrongly perceive that your investments are ok and your wealth accumulation is on track.

Let me illustrate using an example. Let's say, your financial goal is to have $40,000 to buy your dream a car in 10 years. Currently you have $10,000 and decide to invest that amount today and grow it to $40,000 in 10 years. That means you need to get 300% gross return on your money in 10 years. 3 years later, you look at your investments and found that it is worth $14,000. Which means you have got a gross returns of 40% so far. Should you be happy or not with the 40% after 3 years? The answer is not so obvious.

Let's consider another yardstick, the annualised returns. This is basically deriving a compounded return per year that your investment is growing at. The formula is simple, take 40k divide by 10k which gives you 4, apply a power of 1/10 to the number 4, you would get 1.1487. Minus 1 and then multiply by 100% gives you 14.87%. This is the annualised returns that you need per year to achieve your goal.

Let's go back to the example, with this annualized return, after 3 years, we should be expecting to have compounded our money 3 times at 14.87% per year. The result is an investment value of $15,157. Comparing with $14,000, although you have got a gross return of 40%, you are actually short of $1,157. Which means your investments are not meeting your requirements. If you were to compute backwards, you would find out that your actual annualised return is only 11.87%. Not bad but not good enough.

The same measure can be applied to all your investments. Remember that a financial goal is complete only with a dollar value and a time component. Even if you are making money doesn't mean you are meeting your financial goals. Therefore, when you set your financial goals, work out the annualised returns that you need to achieve and then use that over time to make sure you get to your goals.