The required rate of return is the return that your portfolio needs to earn to achieve your goal.You need to do this to understand the types of assets that might help you achieve your goals. If your required rate of return is 2% compared to 6%, your portfolio would consist of different assets to reach your goals. 

Additional resources:

Article: Designing a portfolio to achieve your goals. This article speaks about the considerations with asset allocation after you have worked out your required rate of return.

Tool: Goal calculator/required rate of return calculator. This resource is only available to Morningstar Investor subscibers. You can take out a free, four week trial.* 

Tool: Free calculator to calculate the required rate of return using the article as a guide. 

Proceed to Module 5: How to set yourself up for investing success: Asset allocation

At a very high level, asset allocation is allocating the money that you invest into different types of investments. And many investors think that the most important part of investing is the individual securities you put in your portfolio – which stocks you buy, which ETFs you buy. But in reality, asset allocation may be far more important. One study done by an investor named Robert Ibbotson found that 90% of the variation in returns received came from asset allocation. So definitely something that you need to get right.

Back to course outline.

Module transcript 

Shani Jayamanne: The next step is to calculate your required rate of return. You need to do this to understand the types of assets that might help you achieve your goals. If your required rate of return is 2% compared to 6%, your portfolio would consist of very different assets to reach your goals. There are quite a few variables that go into calculating this, so we've taken the work out of it and created a required rate of return calculator, or a goal calculator.

It takes into consideration your starting balance, inflation, how much you contribute, and how much time you have left to give you a percentage return you need to achieve to get to your goal from your portfolio. We're not the only ones who have done this. So, if you don't have a Morningstar investor subscription or a trial, you can just search for a financial calculator and that will give you the same answer. The calculation is basically just a variation of the time value of money formula.

All that this formula answers is how much will an investment be worth in the future, and that's given a certain rate of return. And the purpose of this formula is to show that it's better to have a dollar in hand today than at a later date. This is because having a dollar today means the opportunity to grow it, but it also holds more value because of inflation. Investing is important because it's not just about growing your money to achieve your goals, it's also about preserving your capital. This means that an important part of the equation is inflation. It means that you're maintaining the purchasing power of your money as well as growing it. So, the required rate of return is a variation of the time value of money formula, answering how much does my investment need to earn to be worth a certain amount in the future.

The time value of money formula is – PV stands for present value and FV is for future value, N is the number of periods and R is rate of return. With your investments, we don't need to figure out the present value, future value, or number of periods. We have all of those variables because they are the variables that we define when we figure out your goal. We're trying to solve for the rate of return. To do this, we rearrange the formula and then it becomes – then we need to ensure that we account for inflation. This then makes the equation.