What’s the real rate of return?

I found this article interesting to share with my fellow bloggers & visitors to my blog....

Source: "The Star" newspaper 11th march 2009 : http://biz.thestar.com.my/  

● Ooi Kok Hwa is an investment adviser licensed by the Securities Commission and managing partner of MRR Consulting.

THE recent reduction in interest rates by Bank Negara caught a lot of depositors by surprise.

Lately, some senior citizens who had been dependent on interest from fixed deposits (FD) for their living expenses have been complaining about the low returns from FD not being able to cover the high inflation rates.

Even though there have been signs that our inflation rate has been heading south from the peak of 8.5% in August 2008 to 3.9% in January, the current 12-month FD rate of about 2.5% is still lower than the latest inflation rate of 3.9%.

If we use the 12-month FD rate as our risk-free rate (instead of the common market practise of 10-year Malaysian Government Securities or MGS rate), the real rate of return to depositors is only minus 1.4% (2.5% - 3.9%).

This explains why some depositors have been quite worried that they may not be able to survive if they continue to depend solely on interest from FD to cover their living expenses.

Even though the Government has encouraged the public to spend money, a lot of people have been holding back their expenditure on some luxury items following the threat of unemployment. They only spend money on necessary items.

Besides, they will continue to place money in FD even though they are aware that the real rate of return is negative.

Based on Bank Negara’s monthly statistical bulletin of 30-year average 1-month, 12-month FD rate and the inflation rate (as measured by the Consumer Price Index or CPI), our real rate of return was positive at 2.9% if we compute it based on the average 12-month FD rate and inflation rate of 6.1% and 3.2% respectively (see table).

The table shows that in an expansionary economy or high interest rate environment, the real rate of return increased to between 6% and 7% during the years 1984, 1985, 1986 and 1997.

However, when our economy went into recession in 1988 and 1998, the real rate of return tumbled to 1.8% and 0.4% respectively.

Hence, even though the real rate of return was minus 1.7% last year – the first time over the past 30 years – we need to understand that the real rate of return will improve when the overall economy recovers.

Investors need to understand that it is not possible to generate the average real rate return of 2.9% every year.

During the current tough economic environment, we also need to understand that the primary concern is to protect capital.

Bank Negara has guaranteed that it will protect money placed in the banks until December 2010.

Hence, we need to make sure that we have enough reserves to help pull us through the current downturn.

According to the rule of thumb of financial planning, we need to have savings to cover four to six months of our living expenses.

We believe that as long as we continue to save money and spend less, it is acceptable to get negative real rate of return during this period.