Setting Expectations for Your Investment Return Rate
B efore you dive into stock market investing (or any type of investment), you’ll want to make sure you understand the return rate you might expect from your investment. The investment return rate can help you set reasonable expectations so you can come up with a strategy that helps you meet your investment goals.
- Any time you’re considering an investment, you’ll want to find a way to measure how that investment might perform. You can look at the investment return rate for any type of investment.
- You’ll find various metrics that let you determine how profitable an investment is. Rate of return, or RoR, and return on investment, or ROI, are two commonly used methods to assess a return of an investment.
- What you might consider a ‘good’ investment return rate will depend on the type of investment you’re making as well as the risk you’re taking on to make that investment.
- The stock market has demonstrated a remarkably consistent return rate when you look at the market over long historical periods.
What Is an Investment Return Rate?
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You can look at the investment return rate to determine how profitable an investment is. This is important basic information, no matter the kind of investment you want to make. Different metrics may be used to calculate how an investment performs. Two common measurements are rate of return and return on investment.
Rate of Return
The rate of return is used to measure an investment’s profit or loss over time. You’ll often see rate of return written as RoR. RoR is the net gain or loss an investment makes over a specified period of time. You express rate of return as a percentage of the initial cost of an investment. Calculating an investment’s RoR determines the percentage change from the beginning of the time period until the end of that period.
You can use the RoR metric to assess a variety of assets, including:
- Real estate.
Gains include income you receive from your investment as well as any capital gains you realize when you sell that investment.
RoR is often referred to as the basic growth rate of an investment. While RoR can be used to evaluate the growth of an investment, it does not account for inflation.
Return on Investment
Return on investment, or ROI, is another financial metric. ROI looks at the growth of an investment from beginning to end and measures how well your investment performs in relation to its cost.
ROI is a ratio that compares that gain or loss from an investment to its cost. Although it is technically a ratio, you’ll often see ROI expressed as a percentage. This figure can help you evaluate the potential return of a stand-alone investment. It can also help you compare returns from several different investments.
ROI is used along with other cash flow measures in business analysis to evaluate as well as rank the attractiveness of various investment alternatives. As an approximate measure of an investment’s profitability, ROI can be used to:
- Measure a stock investment’s profitability.
- Decide whether you should invest in purchasing a business.
- Evaluate a real estate transaction’s results.
Because ROI offers a relatively simple calculation, it is used as a universal, standardized measure of profitability. However, ROI does not account for how long you hold an investment. If you want to compare potential investments, a profitability measurement that includes a holding period in the calculation can sometimes be more useful.
What Is a Good Investment Return Rate?
What you might consider a ‘good’ return depends on the type of investment you make. You’ll also want to take inflation out of the picture when you’re considering investments you can make. After all, investors don’t really care about a dollar amount in and of itself. What you’re really interested in is the purchasing power (in other words, how many cars, gadgets, etc., you can buy) that you get out of your investment.
Taking inflation out of the consideration, you’ll see that your return will vary depending on the type of asset. Here are some general guidelines by asset type:
- Bonds: Bonds offered an average annual return of 5.3% between 1926 and 2018. Investors demand higher returns for riskier bonds.
- Business ownership: Business ownership includes stocks, and the average annual return for stocks since 1926 has been about 10%. Again, investors usually demand higher returns for riskier businesses; the potential for high returns may cause an investor to agree to take on a bigger risk of failure and loss.
- Cash: Over time, flat currencies tend to depreciate in value. Holding cash doesn’t offer a viable long-term investment plan; given enough time, cash becomes worthless.
- Gold: Gold offers a store of value that keeps its purchasing power, but it doesn’t really appreciate over long time periods. Gold can also be extremely volatile from decade to decade, and it frequently moves from big highs to significant lows.
- Real estate: Real estate return demands usually mirror demands for business ownership and stock (without using debt, that is). Yet again, riskier projects will require higher rates of return.
Setting Proper Investment Return Rate Expectations
No matter your investment, you’ll want to set appropriate expectations before diving into investing. Remember that historical rates of return (which anyway are not guaranteed for the future) didn’t follow smooth, constant upward trajectories. If you were investing during the period you’re looking at from the past, you undoubtedly suffered significant losses, many times for years, before experiencing market rebounds. Historical rates capture returns over the long term.
Let’s take a closer look at what kinds of returns to expect when you’re investing in stocks.
Investment Return Rate for Stocks
The stock market’s average historical annual return over the last century has been about 10%. Year to year, though, returns rarely fit the average.
Remember that the long-term 10% average is the headline rate, and you’ll have to reduce that rate by inflation. You’ll usually lose about 2% to 3% of purchasing power each year due to inflation.
Stock market investing is geared to long-term investments. Generally, your stock market investments should be for money you won’t need for five years or more.
When investors reference that 10% figure, they’re usually talking about the S&P 500 index. The S&P 500 comprises around 500 of the largest publicly traded companies in the United States and is thought of as the benchmark measure when it comes to annual returns.
If you look at the S&P 500 between 1990 and today, you’ll see that there have been both up years and down years. However, those fluctuations have averaged out to a positive return over the period of the past 30 years.
That said, if you pick any single year, you’ll find that returns are often far off from that average. Between 1926 and 2014, there were only six times that returns fell into what would be considered the average 8% to 12% range. Every year returns came in much lower or much higher. You should always expect volatility in the stock market.
Most of the time, returns are positive in a given year. While there’s no guarantee, that 10% average has been fairly steady for a long, long time. That fact offers a way to think about reasonable expectations for stock market investment returns: The returns you can expect depend in large part on what the recent past looked like. The lower the recent returns, the higher future returns will probably be. The opposite is also true, though.
Here are some things to keep in mind:
- Don’t get TOO enthusiastic when you’re in the midst of good times. Yes, you’re making money in a bull market cycle, but at least part of the future probably won’t be this good.
- On the other hand, don’t get too down if things look bad. A down market allows you to buy stocks when they’re at attractive valuations while looking forward to higher returns in the future.
- You’ll get that average return only by buying and holding. Short-term trading usually won’t fall into that average and will instead depend on market conditions at a given time.
Down markets can scare investors. If you’re investing for the long term, though, it’s important not to let down markets drive you away. (On the flip side, if you’re in it for the long haul, you won’t want to chase performance spikes too much either.) The truth is, investing during down markets can help drive the total return on investment of your portfolio. Think of investing like a marathon requiring patience, endurance, and the ability to maintain level emotion. The consistent average investment return rate in the stock market means your patience will usually pay off in the end.
L ooking at investment return rate gives you a way to assess the profitability of an investment and determine how to act. While historical stock market returns are not guaranteed to repeat in the future, the remarkably consistent average should give long-term investors some peace of mind when looking at potential success.