Disclaimer: The statements made in this post are the opinion of the author. They should not be viewed as financial advice. Please consult with a financial specialist before making any financial decisions.
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Have you wondered if you’re 401K is making enough money?
Honestly, if you haven’t asked this question, the time to start is now.
How much money you make on an investment is called your return on investment and that number is the driving force behind whether or not you can retire comfortably.
The problem is there are no easy rules of thumb to know if you’re getting a good return on investment.
Is 10% a good rate of return? Is 5% a good rate of return?
Really it all depends on what you compare it to. But first, let’s go over some basics.
Related: Why It is Important to Invest
What Is Return on Investment?
Put simply, a return on investment is just how much money you get back compared to how much you put in and it is a percentage.
So if you invested $10,000 and at the end of one year you have $11,000 that is a 10% return on investment.
Here’s how you calculate that. You take the amount you have and minus the amount you started with to get your total return. (11,000 – 10,000 = 1,000).
Then you divide that number by the amount that you originally invested. (1,000 / 10,000 = 0.1).
Finally you convert that to a percentage by multiplying by 100 (0.1 x 100 = 10%).
Any time you put money in and get money out you can calculate your return on investment.
For a savings account this is basically equal to the interest rate. But this is a better calculation because it also works for dividends, appreciation, and cash flow.
So if you invest in a stock for $100 dollars and one year later it is worth $110 and paid you a $2 dividend (which is a total $12 return) you have a 12% return on investment.
That’s how you get your returns from stocks, not from interest.
Related: The Three Types of Income
What Is A Good Return On Investment?
So now we’re back to the question “What is a good return?” To answer this question you have to know what you’re comparing it to.
To keep it easy let’s just talk about investing in stocks for a moment.
When investing in stocks what you need to compare it to is how well stocks did in general.
Please note that doesn’t mean the average. Averages are helpful starting points, but by definition they are over a long period of time, which won’t help you now.
The average yearly increase in stocks is about 10% (April 2021). So if you’re comparing your 10% return for this year to the average you might think you’re nailing it.
But the total average takes into account the highs and lows of each year. So if you are getting average on a high year then you’re in trouble.
Instead, compare your return on investment to what the market has done year-to-date.
For example, in 2008, by the end of the year, the market return was -37%. (NEGATIVE THIRTY SEVEN!) so if you got a 10% return you were the most amazing investor on the planet.
On the other hand, in 2009 the return was over 26%. So if you only made 10% you were a bit of a dunce.
To put it plainly, if your average return on investment isn’t around or above the year to date average then you’re probably doing it wrong.
But the problem is, if you don’t ask for it, no one is going to tell you how well your portfolio is doing compared to the the year-to-date average.
Watch Out For Fees
There are hidden costs to investing that you must be aware of or you could end up losing a lot of money.
For example, if you invest in real estate you might think that if you get more in rent than you pay for a mortgage each month you are making money so it is all good. But that doesn’t account for the hidden costs of repairs to the house, general maintenance, and occasional vacancy.
Investing in stocks or any investment is essentially the same, but the hidden costs are just called something different.
In stock investing, which is what the majority of people do, that cost is fees.
To understand this let’s take two scenarios. In one scenario you invest with a manager and they manage to beat the average for the year which magically happened to be 10%. They are so proud of it they call you up to celebrate an 11% return.
In the other scenario you invested in what is called an index fund. The basic purpose of an index fund is to mimic the stock market so you end up with as close to the average return as possible. That means you only got a 10% return.
The manager seemed like a better choice right? Wrong.
The manager is running an actively managed fund, to do so they take a 2% cut from your portfolio each year. This is pretty standard.
So the REAL return on investment is actually 9% (11% – 2% = 9%).
On the other hand, an index fund is a passively managed fund so the fees are much less. Definitely under 1% and usually around 0.5%.
So the REAL return on investment is actually 9.5% (10% – 0.5% = 9.5%).
In this case, the lower announced rate of return was actually better when you consider the fees.
And, as it turns out, actively managed funds usually do worse than index funds AND have higher fees.
The Hidden Cost of Inflation
The other important hidden cost that eats at all wealth is inflation. Your return on investment can only be listed as a true rate of return once inflation is accounted for.
Now, on average, inflation runs at about 2-3% per year. Sometimes less, sometimes more. But historically, expecting 2-3% works.
So if your investment is only making you 4% and you are being charged a 1% fund fee, with inflation calculated in there you’ve basically made no money.
If inflation rates increase it will only get harder to make a good return on investment. So be careful of that.
A Good Rate of Return for Real Estate
Unlike investing in stocks, investing in real estate doesn’t compare to a volatile yearly average. This is because most real estate investors invest for cash flow instead of appreciation and there aren’t real estate dividends (I’m not talking about REITs).
But the maddening question remains, is 10% a good rate of return?
Really that depends on who you are and your investing goals. But here are a few things to guide you.
Owning individual real estate is, in general, more risky than owning stocks in an index fund. While stocks fluctuate wildly, historically they have gone up over time.
Real estate, on the other hand, is individual. So while the economy can be good your real estate pick can be awful. You could be over leveraged (having a mortgage that is too high) or you could run into multiple expenses all at once that makes your investment a liability instead of an asset.
Because real estate is riskier, wisdom says you should get a higher return than the less risky index fund. So if you’re only getting 10% returns then you might as well just invest in the stock market.
Because of this I’ve heard a 12% return on investment as a minimum rule of thumb for real estate. But once again, that is up to you.
It is impossible to judge if 10% is a good rate of return for any given investment at any given moment without more information.
But, that is a good place to start when you’re looking at the average return on investment since the stock market has average 10% returns over the long term.
For less risky investments, like bonds, you would expect to get less than that.
For more risky investments, like individual real estate, you would expect to get more.
What return on investment are you getting right now? What do you hope to be able to get? Tell me about it in the comments below.
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A list of definitions used on this blog can be found here.
Return on Investment: How much money you get back, usually measured yearly, on the money you invest in something. For example, if you invest $1,000 and receive $100 back from that in the course of a year then you’ve had a 10% return on investment.
Dividend: Money that is paid back to the people that own portions of stocks (called shares) of certain companies when those companies make a profit. If you own some shares of a company that pays dividends, then you’ll get paid according to how many shares you own.
Appreciation: When the value of an asset increases overtime. For example, your home goes from being worth $100,000 to $105,000. That is 5% appreciation. This is not the same as cash flow or dividends which are other ways that assets can pay you directly.
Cash Flow: Money coming into your pocket from investing (either through stocks, real estate, or other assets). This is NOT the same as income because it doesn’t necessarily require you to work for it.
Year-to-date: The measurement of a metric (such as GDP, or stock prices, or car accident fatalities) from the beginning of the year until now. This number is constantly changes and is only ever solidified after that year is over. For example on March 18, 2020 the stock market year to date was down 28%. But by the end of the year the total growth for the year was up 13%.
Actively Managed Fund: Money invested in stocks that are picked, bought, and sold on your behalf by a fund manager. Generally they have higher fees, and on average they perform worse than the market average.
Passively Managed Fund: Money invested in stocks that are only managed occasionally, or by a computer so there is little to no human involvement. These generally have lower fees. The most famous passively managed fund is the index fund, although there are others.
Liability: Things that take money out of your pocket. This includes all of your monthly and yearly expenses. You will often hear that a home is your biggest asset (the opposite of a liability), but it takes money out of your pocket each month in the form of a mortgage, taxes, and insurance, so it is a liability.
Asset: Things that put money into your pocket every month (or year). Sometimes equity in your house is also included as an asset, but I prefer not to include it. A car loses value every year (depreciates) so it is NOT an asset.