When are returns too high or too low?

Within and outside our community, it is common to hear retail investors complain about being duped of their life savings through certain investments. 

However, this can easily be avoided because many of these investment schemes have obvious flaws. The most obvious flaw is that these investments promise returns that are too high. But how can you tell when a return is too high or too low? How to detect this and make smarter investment decisions will be our focus today. 

The first thing to consider is setting your return expectations. We advise retail investors to seek a minimum return equal to the inflation rate of the currency of their investment. Any return below this can be considered too low.

This ensures that their investment can at least buy the same amount of goods/services as before. In practical terms, if you are investing in dollars, you want a minimum return of 2%. Why? Because the US inflation rate has been around 2% over the past decade. If you are investing in naira, you want a minimum return of 12%, as this is the average inflation rate over the past decade in Nigeria. 

With this expectation in mind, the second thing to consider is the risk-free rate in the country of your investment. The risk-free rate is the rate at which the government is borrowing money (government borrows for under a year with treasury bills). It is risk-free because governments are the most credit-worthy borrowers (compared to companies and households), and they will always repay their debt, especially if it was borrowed in the local currency (like the FG borrowing in naira). 

What this means for you as an investor is to recognise the risk-free rate as a benchmark for returns. In simple terms, any investment that is riskier than lending to the government must pay you a higher return. 

Knowing your expected returns and risk-free rate gives you valuable insight on the kind of investments you can add to your portfolio. For instance, if the risk-free rate is higher than your expected return, you will be comfortable to add government debt to your portfolio. However, if the reverse is the case, we say the return is too low. Then you might seek other opportunities that will give a return that will compensate for inflation.

The second scenario is a big concern for investors around the world because governments are currently borrowing at the cheapest interest rates ever. This means low-risk investments will not pay high returns. In Nigeria, for instance, the rate on treasury bills fell from 13-14% in 2019 to less than 1% in 2020 before rising back to 10% as at today. 

However, searching for high returns means you have to take on more risks. While high-risk investments tend to pay high returns, this is not always the case. This means you have to be careful when considering investment options beyond treasury bills for your portfolio. 

So how do you decide when an investment is too risky? 

Compare the return the investment is promising to the risk-free rate. Our rule of thumb is that when an investment is offering you 5% above this rate, be cautious. Caution requires you not to allocate too much of your portfolio or what you cannot afford to lose into very risky investments. 

Let’s look at two scenarios to determine returns that are too risky. 

First, the risk free rate for a one year government treasury bill is currently around 10%. The implication for you as an investor is to investigate any investment opportunity offering above 15% per annum. A 15% rate per annum is the same as 1.3% per month (divide 15% by 12). 

Secondly, looking at past data. The risk-free rate was highest between 18-20% per annum in Nigeria. 5% above that is 25% interest rate per annum or 2.1% monthly interest rate.

In the final analysis, you must know that any investment that promises you more than 1.3%-2.5% per month in Nigeria is already risky. Ensure you do your due diligence before committing to that investment. 

Next week, we will talk about how to conduct due diligence on investment opportunities. 

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