Building wealth isn’t as confusing of a process as some people believe. In fact, it’s pretty straightforward. You start by budgeting and living below your means so that you’re able to save. Once you have savings, you use them to buy assets that generate a rate of return.
However, it’s important to realize that not all assets are equal. Each one has its positives, negatives, and a certain degree of risk. These factors, along with many others, affect the rate of return you’ll earn which impacts the length of time it takes before you’re able to live the life of your dreams!
What Is A Rate of Return?
Most people invest their capital to make money and the profitability of each investment they buy gets measured by its rate of return. This metric compares your financial gains or losses with the original price you paid for the asset to determine how well the investment performed.
Rates of return (RoR) are expressed as a percentage and show you how hard your money is working. The higher they are, the faster your money is growing, compounding, and helping you to reach your goals!
How To Calculate A Rate of Return
A rate of return shows the amount of money you earned on an investment relative to the price you paid for it. You calculate it by taking:
The rate of return you earn, helps you project your net worth into the future. It also allows you to make an apples-to-apples comparison between your investment options so that you’re able to determine the best use of your money, too!
For example, imagine you have the option of investing in two separate companies. Company A is expected to produce a $500 profit based on a $10,000 investment, while Company B projects a $75 gain on a $750 investment. At first glance, $500 is more than $75 which would leave you to believe that Company A is the better choice.
But, calculating the rate of return changes the outcome. The return on Company A is 5% while Company B’s is 15%. So, despite Company A having a larger financial gain, Company B gives you a higher rate of return. As long as they both have equal risk, then Company B is the better choice to make!
What Is A Good Rate Of Return?
There are thousands of different investment options for you to choose from. You can invest in traditional assets like stocks, bonds, and index funds. Or you could buy alternative assets, such as farmland, wine, and rare art.
However, determining whether an asset will produce a good rate of return is subjective. It’s based on each investor and their expertise, investment criteria, and risk tolerance.
Risk-averse investors have a money personality that prefers stable assets over volatile ones. They make investments that offer predictability and safety, yet have lower rates of return (not that there’s anything wrong with that).
Whereas individuals who accept risk are more willing to take chances. They’ll put their capital in greater jeopardy for the chance of earning higher profits. Since they’re willing to face a greater amount of uncertainty, they’ll require a risk premium or a higher rate of return to invest.
But, it’s impossible to determine the rate of return on a risky asset before you buy it. The formula requires that you sell in order to calculate your yield and determine how well your investment performed. As a result, investors look for ways to reduce their risk and have some degree of certainty before they’re willing to invest their hard-earned capital.
Historical Rates of Return (1926-2020)
Investment returns are not guaranteed and most will vary from one year to the next. This year they may be soaring while the next year could be completely different.
As a way to reduce risk, many investors accept the Mean Reversion Theory. This theory says that asset prices will fluctuate on a day-to-day and year-to-year basis. But, over the long term, they’ll perform close to their historical rates of return.
Below are common assets that investors use as a place to store value. Each one shows its real rate of return, which accounts for and is net inflation.
- Cash: -2.6% RoR
- Your House: Negative RoR when you include mortgage payments, maintenance, and other hidden costs
- Bonds: 3.4% RoR
- Stocks: 7.7% RoR
- Investment Real Estate – RoR varies on many factors, including purchase price, leverage, rehab, and property management costs
- Investing in yourself – Potentially infinite RoR
***Past performance does not guarantee future rates of return***
Infinite Rate of Return
The best possible yield you can earn on your money is an infinite rate of return. This is generated when you’re able to withdraw your entire initial investment while retaining ownership in the asset. Since you no longer have any capital invested, the future gains you receive are essentially free money!
For example, imagine you buy 1,000 shares of 2THEMOON stock for $10 per share. A year later, they’re worth $20 per share. If you sell 500 of them, you’d receive your initial $10,000 investment back and still have 500 shares in the market. Your initial investment is now zero which gives you an infinite rate of return!
Investment real estate is another asset where you can generate infinite returns. For example, imagine you buy an ugly house for $50k. You spend another $25k fixing it up and when you’ve finished, it’s worth $100k. If you put a $75k mortgage on the property, you’d recoup your full investment and have equity and cash flow, too!
Calculating your rate of return will help you understand how hard your investment capital is working. But, it doesn’t tell you the whole story because it’s missing one key component – time.
For example, imagine you invest $5,000 and generate a $2,500 profit. You’ll have made a 50% rate of return which is great!
But, what if it took 10 years for it to happen? Then, your annual rate of return gets reduced to 4.14%, which isn’t nearly as exciting.
Before you buy an asset, you still should consider its rate of return. But, it shouldn’t be the only metric you look at. You also need to evaluate its risks, your investment options, and the way each helps you accomplish your financial goals!
What’s the lowest annual rate of return you’re willing to accept? Comment below.
Leave a Reply