IS 16% ROI ENOUGH? If NO, How much is enough?

In Property by redsocks

New investors often don’t know what a “good” rate of return is on a well-constructed long-term portfolio. The answer depends on how the portfolio is constructed and varies by asset class.

One of the main reasons new investors lose money is because they chase after unrealistic rates of return on their investments, simple. Whether they are buying stocks, bonds, mutual funds, real estate, or some other asset class.

This happens due to a lack of experience. Most folks just don’t understand how compounding works. Every percentage increase in profit each year means huge increases in your ultimate wealth over time.

To provide a stark illustration, $10,000 invested at 10% for 100 years turns into $137.8 million. The same $10,000 invested at twice the rate of return, 20%, does not merely double the outcome, it turns it into $828.2 billion. It seems counter-intuitive that the difference between a 10% return and a 20% return is 6,010x as much money, but it’s the nature of geometric growth.

What’s a Good Rate of Return?

When it comes to answering the question, “What is a “good” rate of return on your investments”, I find myself frequently reiterating the truism that past performance is no guarantee of future results, and that even the best-structured portfolio or investment plan can result in permanent capital losses. I think about risk a lot. It’s in my nature. In fact, I believe people don’t think about risk enough. Things like the total decimation of the Austrian stock market upon the annexation of Austria by Nazi Germany have happened, can happen, and will happen again at some point in the future.

There are no guarantees of any kind in life.

With that said, I think the only reasonable, academic position a person can take if they assume that civilization will remain relatively stable is to answer that determining a “good” rate of return on your investments is probably easiest if we examine the nearly 200 years of data from Ibbotson & Associates, a data research firm that tracks financial market history.

It’s not perfect for the reasons we just discussed, as well as several others, but it’s the best we have.

To accomplish this, the first thing we need to do is strip out inflation. The reality is, investors are interested in increasing their purchasing power. That is, they don’t care about “dollars” or “yen” per se, they care about how many cheeseburgers, cars, pianos, computers, or pairs of shoes they can purchase.

When we do that and look through the data, we see the rate of return varies by asset types:

• Gold: Typically, gold hasn’t appreciated in real terms over long periods of time. Instead, it is merely a store of value that maintains its purchasing power. Decade-by-decade, though, gold can be highly volatile, going from huge highs to depressing lows in a matter of years, making it far from a safe place to store money you may need in the next few years. (To illustrate how gold itself very rarely changes in value — it is the things around gold the fluctuate — I once researched fifteen years of gold prices in various currencies on blog for my own benefit.)

• Cash: Fiat currencies are designed to depreciate in value over time. In fact, $100 in 1800 is worth only $8 today, representing a loss of 92% of value. Burying cash in coffee cans in your yard is a terrible long-term investing plan. If it manages to survive the elements, it will still be worthless given enough time.

• Bonds: Historically, good, quality bonds tend to return 2% to 4% after inflation in normal circumstances. The riskier the bond, the higher the return investors demand.

• Business Ownership, including Stocks: Looking at what people expect from their business ownership, it is amazing how consistent human nature can be. The highest quality, safest, most stable dividend-paying stocks have tended to return 7% in real, inflation-adjusted returns to owners for centuries. That seems to be the figure that makes people willing to part with their money for the hope of more money tomorrow. Thus, if you live in a world of 3% inflation, you would expect a 10% rate of return (7% real return + 3% inflation = 10% nominal return). The riskier the business, the higher the return demanded. This explains why someone might demand a shot at double-or triple-digit returns on a start-up due to the fact the risk of failure and even total wipe-out are much higher. To learn more about this topic, read Components of an Investor’s Required Rate of Return.

• Real Estate: Without using any debt, real estate return demands from investors mirror those of business ownership and stocks. The real rate of return for good, non-leveraged properties has been roughly 7% after inflation. Since we have gone through decades of 3% inflation, over the past 20 years, that figure seems to have stabilized at 10%. Riskier projects require higher rates of return. Plus, real estate investors are known for using mortgages, which are a form of leverage, to increase the return on their investment. The present low-interest rate environment has resulted in some significant deviations in recent years, with investors accepting cap rates that are substantially below what many long-term investors might consider reasonable.

Keep Your Expectations Reasonable

There are some takeaway lessons from this. If you’re a new investor and you expect to earn, say, 15% or 20% compounded on your blue chip stock investments over decades, you are delusional. It’s not going to happen.

That might sound harsh, but it’s important that you understand: Anyone who promises returns like that is taking advantage of your greed and lack of experience. Basing your financial foundation on bad assumptions means you will either do something stupid by overreaching in risky assets, or arrive at your retirement with far less money than you anticipated. Neither is a good outcome, so keep your return assumptions conservative and you should have a much less stressful investing experience.

What makes talking about a “good” rate of return even more confusing for inexperienced investors is that these historical rates of return — which, again, are not guaranteed to repeat themselves! — we’re not smooth, upward trajectories. If you were an equity investor over this period, you suffered sometimes jaw-dropping, heart-pounding losses in quoted market valuation, many of which lasted for years. It’s the nature of dynamic free market capitalism. But over the long-term, these are the rates of return that investors have historically seen.

(The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal).

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