A target return is simply the rate of return on an investment that an individual or business wants to earn. People have different reasons or objectives in mind when they choose to use target returns as an investment tool. The target return objective matters because it determines how the target return is calculated.
Income as Target Return Objective
Some people, such as retirees, live on income from their investment portfolios. The target return objective is to provide enough spending money and maintain the value of the portfolio after allowing for taxes and inflation. Suppose a retiree’s investment portfolio has assets of $600,000. She wants to withdraw 3 percent, or $18,000, each year to supplement her other retirement income. Inflation and taxes on investment earnings total 4 percent. Added together, this is a target return of 7 percent to achieve the objective of maintaining the value of her nest egg and producing the income she wants.
Growth as Target Return Objective
An investor may be focused on wealth-building instead of income. An example is the person who regularly contributes to an individual retirement account to accumulate a nest egg for retirement. For this investor, the target return objective is to reach a specific dollar value within a certain length of time. Suppose she and her spouse decide $750,000 in 25 years is sufficient to assure a comfortable retirement and can contribute a total of $750 each month to their IRAs. Determining the target return from a specific dollar goal requires a financial calculator tool due to the complexity of the math. There are suitable calculators readily available online (see Resources). In this example, the target return needed to achieve the objective of $750,000 after 25 years is 8.59 percent.
Return and Risk
It’s tempting to take the view that a good target return is “as much as possible.” Some investors do adopt profit maximization as their objective. However, as the potential return of an investment increases, the risk of loss also goes up. Thus, investments like stocks and junk bonds offer high returns but carry a significant risk of losing money. Insured savings and government bonds are low-risk investments but generate very limited earnings. Using a target return objective to identify your requirements lets you choose the best mix of investments to minimize risk and maximize gain.
Target Return and Pricing Strategy
Introducing a new product or opening a new store represents an investment for a business. Companies may use target return objective as a pricing strategy. Suppose the company management believes it can sell a given number of widgets. A 20 percent return before taxes is chosen as the target return. A formula is used to set a price that will achieve the 20 percent target return objective if the sales goal is met. Firms have to take other factors into account, such as the prices competitors charge, so using a target return objective is usually one part of the overall pricing policy.