Before you invest your money, there is likely one big question on your mind: How much are you going to earn? This is known as the rate of return.
The rate of return is expressed as a percentage of the total amount you invested. If you invest $1,000 and get back your original investment and an additional $100 in interest, you’ve earned a solid 10 percent return.
Numbers don’t always tell the full story, though. You’ll need additional context to accurately assign that subjective “good” to your return.
What risks are standing in the way of your return?
Let’s say you need a ride to the airport. It’s 30 minutes away, and you’re running a bit behind schedule. A friend promises to get you there in 15 minutes, but the ride involves driving 100 mph, running red lights, darting in and out of traffic and fearing for your life. Was that “return” of 15 minutes of your time really worth the white-knuckle ride that came with risks of an accident and injury? Probably not.
Now, think about a real financial example: a 2 percent return. On the surface, this may not sound impressive. However, let’s say you earned that 2 percent in a federally-insured, high-yield savings account. In that case, it’s a very good return since you didn’t have to accept any risk whatsoever. If that 2 percent figure came after you spent the past year following Reddit forums to chase the latest meme stock, your return doesn’t look so good. You had to accept loads of risk while likely losing loads of sleep during each large valuation swing.
Average rates of return
When you’re evaluating potential places to put your funds, think about the type of investment you’re considering, how long you’re planning to invest the money and the risks you’ll need to take along the way.
Take a look at how some of the most well-recognized asset classes have performed over the past 10 years.
|Investment||Average annual return|
|U.S. stocks (based on the S&P 500 Index)||15.35%|
|International stocks (based on MSCI EAFE Index)||6.63%|
|Bonds (based on the Bloomberg U.S. Aggregate Bond Index)||3.39%|
|Real estate (based on FTSE Nareit All Equity REIT Index)||8.63%|
One important note to keep in mind: You may have read headlines about what constitutes a “good” return on bitcoin and other types of cryptocurrency, but these are extremely volatile and lack a proven track record. Comparing them against investments with decades-long histories that have weathered multiple severe market downturns is simply impossible.
What if your investment is below its average?
One year, the stock market might be up 14 percent. Two years later, it might be down more than 35 percent (as it was in 2008). Earning that average means taking the good with the bad, leaving your money invested and reinvesting all distributions — even when the index is under-performing.
Stocks, junk bonds, real estate and other higher-risk investments can generate negative returns over short time frames. Over longer periods of time, the merits of owning real estate that increases in value, or a stock index fund whose collective holdings are generating ever-increasing earnings are what generate the higher return on investment that attracted your attention in the first place.
Understanding inflation’s impact on your return
The rate of return isn’t the only number you need to consider. You also need to pay close attention to the rate of inflation to get a true picture of what your investment can actually purchase.
If you earned a 5 percent return on an investment during a time when inflation increased 5 percent, your buying power is still the same. On an after-inflation, or real, return basis, your return on investment is zero.
Cash investments often trail, or at best, keep pace with inflation. This is why you’ll have to accept some degree of risk in order to achieve your financial goals. For example, if you keep all your money in CDs and a savings account for decades, the amount of money in your account will increase, but the buying power of that money will likely shrink. So, for long-term investment goals like retirement, a heavy allocation toward stocks — particularly in the earlier part of your professional career — is a time-tested way to outpace inflation and create wealth.
Look to the future — not the past
Whenever you invest in non-insured accounts, you’re going to see some fine print: “Past performance does not necessarily predict future results.”
The Securities and Exchange Commission (SEC) requires that disclosure on mutual funds to make everyday investors aware of the reality that history doesn’t repeat itself. Make sure you heed the SEC’s warning. If you focus all your energy on trying to mirror past returns, you can waste your time chasing one-hit wonders and having unrealistic expectations about your money. Worry less about what’s in the rearview mirror and more about what’s staring at you through the windshield. That’s how you’ll be able to spot the opportunities that can lead to great — not just good — returns on your investments.
And when you’re looking through that figurative windshield, be sure to look at the entire road of possibilities in front of you, not just one point on the horizon. By diversifying your portfolio across various assets, you’ll be able to optimize your return on investment based on the risks you’re willing to take.