One of the main reasons new investors lose money is that they chase after wild rates of return, whether they are buying stocks, bonds, mutual funds,real estate, or some other asset class. That may be because most people don’t understand how compounding works. Every percentage increase in profit each year could mean huge increases in your wealth over time.
To provide a starkillustration, $10,000 invested at 10% for 100 years could turn 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 may seem strange that the difference between a 10% return on investment (ROI) and a 20% return is 6,010 times as much money, but it's the nature of compound growth. A further example is shown in the chart below.
What Is a Good Rate of Return?
Before we can determine what would be a good rate of return, we have to think about inflation, which decreases the value of currency over time. Prices go up. You'd need more money in the future just to buy the same amount of goods for a certain amount today.
Many people who invest do so to increase their buying power. That is, they don’t care about “dollars” or “yen” per se, they care about how much they can buy with that money.
When we look through the data, we see that the rate of return varies by asset types:
Gold
For the most part, gold hasn’t gained much in real value over the long term.Instead, it is merely a store of value that keeps its buying power. Decade by decade, though, the value of gold changes often, going from huge highs to extreme lows over just a few years.
Note
These frequent changes in rate of return make it far from a safe place to store money you may need in the next few years.
Cash
Money, or fiat currencies, can depreciate in value over time. Burying cash in coffee cans in your yard is a terrible long-term plan. If it manages to survive the weather, it will still be worth less, given enough time.
Bonds
From 1926 through 2018, the average annual return for bonds was 5.3.%. The more risk a bond carries, the higher the return investors demand.
Stocks
Since 1926, the average annual return for stocks has been 10.1%. The riskier the business, the higher the return investors demand.
Real Estate
Without using any debt, real estate return demands mirror those of business ownership and stocks. We have gone through decades of about 3% inflation over the past 30 years.
Projects with more risk may result in higher rates of return. Real estate investors are known for using mortgages, which are a form of leverage, to increase the return on their investment.
Note
The present low-interest-rate landscape has resulted in some big changes in recent years, with people accepting real estate returns that are far below what many long-term investors might consider reasonable.
Keep Your Hopes In Check
If you're a new investor and expect to earn 15% or 20% compounded returns on your blue-chip stock holdings over decades, you expect too much. It's not going to happen. That might sound harsh, but you need to know it. Anyone who says you'll get returns like that is taking advantage of your greed and lack of experience. Basing your portfolio on bad assumptions means that you will either do something reckless, like pick risky assets, or retire with much less money than you thought. Neither is a good outcome. So, keep your hopes in check, and you should have a much less stressful time investing.
Talking about a "good" return can be complex for new investors. That's because these results—which are not guaranteed to be repeated—were not smooth, upward rises. If you are invested in stocks, you periodically see huge drops in value. Many of these drops last for years. It's the nature of free-market capitalism. But over the long term, the rates above are the rates of return that investors have historically seen.
Frequently Asked Questions (FAQs)
How do you get a 20% return on your investment?
A 20% return is possible, but it's a pretty significant return, so you either need to take risks on volatile investments or spend more time invested in safer investments. Some stocks do earn 20% within a year or less, but if you don't trade those kinds of stocks correctly, that volatility could result in 20% losses rather than gains. Relatively safer investments may see less volatility in an average year, but if you have a long enough timeline, you have the potential to earn that 20% return eventually.
When do investors expect a higher rate of return on their investments?
The more risk associated with an investment, the higher returns the investor will expect. If the potential returns of two investments are identical, and one has less risk, then investors will choose the less risky investment. As investments get riskier, they must offer the potential for higher returns, or else they won't attract investors.
As a seasoned financial expert with a deep understanding of investment principles and financial markets, I can attest to the crucial importance of comprehending the dynamics of compounding and the impact it has on wealth accumulation over time. The evidence supporting this assertion lies in the fundamental principle that small, incremental increases in annual returns can lead to significant growth in the long run, as exemplified by the illustration of $10,000 growing at 10% for 100 years resulting in $137.8 million, and at 20%, turning into a staggering $828.2 billion.
Now, delving into the concepts presented in the provided article:
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Compounding and Rate of Return: The article underscores the concept of compounding, emphasizing how each percentage increase in annual profit can contribute to substantial wealth growth over time. It stresses that the nature of compound growth is such that a higher rate of return leads to exponential increases in the final wealth outcome.
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Inflation and Buying Power: Before determining a "good" rate of return, the article introduces the concept of inflation, explaining how it erodes the value of currency over time. It emphasizes the importance of considering inflation when evaluating returns, as investors aim not just for absolute gains but to maintain or increase their buying power.
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Asset-Specific Returns: The article provides insights into the varying rates of return for different asset classes:
- Gold: It notes that gold, while serving as a store of value, experiences frequent changes in its rate of return, making it less suitable for short-term money storage.
- Cash: Fiat currencies, represented by cash, can depreciate over time, making burying cash a poor long-term strategy.
- Bonds: The average annual return for bonds from 1926 through 2018 was 5.3%, with higher-risk bonds demanding higher returns.
- Stocks: Since 1926, stocks have averaged a 10.1% annual return, with riskier businesses correlating with higher return expectations.
- Real Estate: Real estate returns, without leverage, mirror those of business ownership and stocks. The use of leverage, such as mortgages, can impact returns.
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Expectations and Risk Tolerance: The article advises new investors to keep their expectations realistic and not to chase after excessively high compounded returns. It stresses the need to understand the nature of free-market capitalism, where stocks can experience significant drops but historically have shown positive long-term returns.
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FAQs on Returns: The article addresses common questions regarding returns, emphasizing that a 20% return is possible but may involve taking risks on volatile investments. It also highlights the relationship between risk and expected returns, stating that riskier investments must offer higher potential returns to attract investors.
In conclusion, a nuanced understanding of compounding, inflation, and the specific characteristics of different asset classes is essential for making informed investment decisions and managing expectations over the long term.
