Smarter investments mean higher ROI...
BACK in 1979 and 1980, I remember my poor dad talking about the rate of return he was getting on his bank's certificates of deposit, writes Robert Kiyosaki, author and editor of Rich Dad Poor Dad, in Addison Wiggin's Daily Reckoning.
It seemed normal at the time, but their rate was 18%. Who wouldn't like an 18% return on a CD today?
What I found really interesting though was when the savings-and-loan crisis hit in the 1980s: the bank retracted the 18% interest rate and basically cancelled the outstanding CDs.
Today, if you invested $10,000 in a five-year CD at the national average rate of 1.15%, you would have earned $592 in interest at the end of the five years.
I have always found it amusing that people think saving money is smart. This strategy is not smart if your goal is real wealth.
I often write about investing for cash flow. But the reality is that when it comes to investing, cash flow isn't the only thing I pay attention to.
In my investments, I have two key focuses: cash flow and return on investment (ROI), which goes hand-in-hand with cash flow.
Your return on investment is exactly that: the amount of cash the money you invested is paying or returning to you. In other words, how hard is the money you invest working for you?
Most stockbrokers or real estate agents talk about a 10% return as a good return. But in most cases, that is a 10% return in capital gains, not cash flow. It's not real money until you sell the entity. Again, that is the problem with getting your financial education in the S quadrant. (In most cases, S can stand for sales.)
As an investor, I must know what kind of ROI the salesperson is talking about. Is it 10% in cash flow or capital gains, and what are the tax consequences? Am I punished with taxes, or given tax breaks?
More importantly, how do I achieve an infinite return (aka "money for nothing" in which I see returns without putting my own money into the deal)?
There are several ways to calculate return on investment depending on what you're measuring. Some are more complicated than others.
Some formulas take depreciation into account when calculating ROI. Another formula assumes that the cash flow you are receiving is being re-invested immediately and takes that into account. Each formula is accurate, depending on what you want to measure.
Personally, unless it's absolutely necessary, I like to follow the K.I.S.S. principle and keep my calculations super simple. So, when I refer to ROI, I typically mean what is called cash-on-cash return on an investment. After all, I'm only interested in one thing: how much cash is flowing into my pocket. It's all about the cash flow.
Figuring out your cash-on-cash return is easy. The equation is:
The annual cash flow / Amount of cash invested = Cash-on-cash return on investment
For example, let's assume you're buying a rental property that costs $100,000 using a 20% down payment of $20,000. Each month your property cash flows $200. That's an annual cash flow of $2,400.
To calculate your cash-on-cash return would look like this:
$2,400 / $20,000 = 12% cash-on-cash ROI
Not a bad return, but not stellar either.
Let's take a look at another example. Say you purchase $2,500 in stock that pays an annual dividend of $100.
$100 / $2,500 = 4%
Well, at least you're getting a return.
The point of showing the two examples, a rental property and a stock investment, is to illustrate that not all investments are created equal. Understanding how much cash flow you're making and what kind of ROI that cash flow represents helps you to know how hard your investments are working for you.
The whole reasoning to focus on cash flow is that you want your money working hard for you so that you don't have to work hard for your money. If you have an investment making 4% ROI for you, then it's not working very hard. If, you have one making you 50% ROI, well then you have a real team member.
The years between 2000 and 2010 have been called the "Lost Decade". For millions of amateur stock market investors, their ROI was less than two%, for some even zero% when you account for inflation.
In real estate, millions of people lost everything – in some cases, more than everything if they buried themselves in debt trying to save a home that they never really owned. Some professional investors also lost everything.
However, for a few professional investors in both stocks and real estate, the "Lost Decade" has been their "Best Decade".
One unfair advantage of a financial education is the possibility of a much higher ROI on your money, with much less risk, and (in many cases, with the help of a good accountant) zero taxes.
Today, when someone calls me pitching an investment, if the investment he or she is proposing does not guarantee a 28% return the first year, cash in my pocket, I turn the investment down. Why risk my money when I can get a government-guaranteed return?
The lowest return I will consider is 28%. On many of my investments, even a 100% or 250% return is not enough. I want an infinite return.
With little financial intelligence, you can typically expect a low return on your investments. Why? Because you won't know what to look for in investments that generate higher returns and will probably end up in investments or savings plans that offer low yields.
This is why financial planners recommend mutual funds, CDs, and savings to people with little financial intelligence. This is also why so many people get taken in when they are promised too-good-to-be-true returns on investments they know nothing about.
Obtaining and sustaining a high rate of return takes financial education and experience. There is no secret sauce, no magic pill. It takes putting in the time and effort to study, research, and taking action.