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Joshua Kennon co-authored “The Complete Idiot’s Guide to Investing, 3rd Edition” and runs his own asset management firm for the affluent.
Updated January 31, 2020
One of the main reasons new investors lose money is because they chase after unrealistic rates of return on their investments, whether they are buying stocks, bonds, mutual funds, real estate, or some other asset class. Most folks don’t understand how compounding works. Every percentage increase in profit each year could mean 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. Another example is illustrated in the chart below.
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:
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.
Fiat currencies can depreciate in value over time. 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.
From 1926 through 2018, the average annual return for bonds has been 5.3.%. The riskier the bond, the higher the return investors demand.
Looking at what people expect from their business ownership, it is amazing how consistent human nature can be. Also, since 1926, the average annual return for stocks has been 10.1%.
The riskier the business, the higher the return demanded. It explains why someone might demand a shot at double- or triple-digit returns on a startup due to the fact the risk of failure and even total wipe-out are much higher.
Without using any debt, real estate return demands from investors mirror those of business ownership and stocks. We have gone through decades of about 3% inflation over the past 30 years.
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.
There are some takeaway lessons from this. If you’re a new investor and you expect to earn 15% or 20% compounded on your blue-chip stock investments over decades, you are expecting too much; it’s not going to happen.
That might sound harsh, but you must 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 irresponsible 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—were not smooth, upward trajectories. If you were an equity investor over this period, you sometimes suffered 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.