Hurdle rate
A hurdle rate is the minimum rate of return on a project or investment required by a manager or investor. The hurdle rate denotes appropriate compensation for the level of risk present; riskier projects generally have higher hurdle rates than those that are deemed to be less risky.
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My investing behaviour vastly changed once I started using hurdle rates. The concept of a hurdle rate wasn’t new to me but the fact that you can anchor your investment strategy around a hurdle rate was a powerful revelation.
If you are investor, you *must* have an hurdle rate in mind. If you don’t you run the risk of an investment strategy that’s meandering about without a clear direction.
But, you may ask, why not just let it be as much as possible? Fair question. The answer if that you are mostly going to be misled in your investment decisions if you don’t have a rate in mind. If you are risk taking, you are going to risk more than you need to, perhaps ending up with losses. If you are otherwise, it is easy to just let your money stay as a pile of cash. Having a hurdle rate lets you know whether your decisions are prudent. Poor investment decisions where hurdle rates are not factored happen more than you think.
For instance, an insurance agent could easily advise you to buy an insurance product with a yield of 3% and have your money locked up for 30 years. Are you comfortable with a 3% yield with loss of liquidity over 30 years? If you had a hurdle rate and that happens to be 2%, then it seem it would be. If your hurdle rate happens to be 6%, then clearly, this is a poor choice.
So, how to choose a hurdle rate? I believe hurdle rate should at the very least be the rate of inflation in the country you live in. As per world bank data, since 1960, India’s inflation has been an average of 7.59%, Singapore’s has been 2.62%, US has been 3.8% and Australia has been 4.9%. If your target is lower than that, your money is eroding value over time. I have put the data in google sheet so you can play with it. Yearwise data is currently hidden; unhide them to scan across that.
However, if you believe that the money we invest today should serve us financially at some point of time, then you will need to aim a little higher.
For investments that I hold in dollar currencies (AUS, SG, US), I set myself a hurdle rate of 10%. The reasoning is a combination of:
- It is big enough that if I achieve it, then my financial goals have a good chance of being met
- It is achievable (S&P 500 over the past 50 years as done about 9.7%. I did a back calculation on my unit trust dollar currency investments over the past 6 years and found that they return between 6.5% and 7.5%. They were charging management fees of about 2.5% to 3%. So, actual returns ranged between 9% to 10.5%.)
- It is a nice round number
Note that I am not indicating I achieve it, merely that I set myself the goal. Whether I achieve it or not, and how often, is subject of a different post.
