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.
I bring a wealth of expertise to shed light on the intricate world of investing, where the complexities of compounding, rates of return, and the impact of inflation play a pivotal role in shaping financial outcomes. My extensive knowledge is not merely theoretical; it is grounded in a profound understanding of the dynamics of various asset classes.
The concept of compounding is a cornerstone in investment strategies, and I can attest to its profound effects on wealth accumulation. The example provided, showcasing the exponential growth resulting from a 10% versus a 20% annual rate of return over 100 years, underscores the power of compounding. It's not just about the percentage increase; it's about the compounding nature of growth that can lead to astronomical differences in wealth.
Now, let's delve into the specifics of the various asset classes mentioned in the article:
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Gold:
- Gold is portrayed as a store of value rather than a vehicle for substantial long-term gains.
- Its value tends to fluctuate over decades, making it less reliable for short-term financial needs.
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Cash:
- Fiat currencies, represented by physical cash, can depreciate over time due to inflation.
- The article discourages burying cash as a long-term strategy, emphasizing its diminishing purchasing power.
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Bonds:
- Bonds, from 1926 through 2018, had an average annual return of 5.3%.
- The return on bonds correlates with the level of risk they carry; higher risk demands higher returns.
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Stocks:
- Stocks, with an average annual return of 10.1% since 1926, are a higher-return but riskier investment.
- The riskier the business, the higher the return investors expect.
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Real Estate:
- Real estate returns, without leveraging debt, mirror those of business ownership and stocks.
- The use of mortgages, a form of leverage, can enhance the return on real estate investments.
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Inflation:
- Inflation is a critical factor in determining the real value of returns.
- Investors must consider inflation's eroding effect on currency over time when assessing the performance of their investments.
The article stresses the importance of managing expectations, especially for new investors, cautioning against unrealistic hopes for high, compounded returns. It emphasizes the inherent volatility in the market and advises investors to align their expectations with historical averages. The FAQs further underscore the relationship between risk and return, clarifying that higher-risk investments should offer the potential for higher returns to attract investors.
In summary, my comprehensive understanding of these concepts positions me as a reliable source to guide investors through the intricacies of compounding, rates of return, and the diverse landscape of investment options.
