Budget. Save. Invest. Repeat.
As part of your plan for the future, you budget to save. Your stockpile grows and you progress to the wealth accumulation phase on the Hierarchy of Financial Needs.
With this advancement, your focus shifts to investing. You use your money to buy assets and hope to generate a good return. This allows your money to make more money!
But, good returns are relative to each individual. What one investor considers acceptable, may not be enough for the next.
You need to determine what is a good return on your money. It will help you balance risk vs reward, invest in the appropriate assets, and reach your financial goals faster!
The goal of investing is to make your money multiply. You buy and use assets as a way to grow your nest egg.
A rate of return is a measure of investment performance. It shows the amount of money that’s made or lost as a percentage of the initial investment.
You make money investing through the cash flow and capital gains that you receive. When these profits get reinvested, your returns grow even larger with the power of compounding!
The higher your yield, the harder your money is working for you. This helps you reach your financial goals faster, without needing to save and invest as much capital!
A rate of return is a useful metric. It helps you evaluate different investment opportunities and their expected outcomes. You can use it as a gauge to identify the assets that are right for you on your path to wealth creation.
The two main factors that affect yield are inflation and risk. Inflation is a measure of purchasing power. It‘s used to show the rate of change in the price of goods and services. The higher it is, the less money you’ll earn.
For example, imagine you buy the XYZ Mutual Fund. It’s expected to earn a good return of 8% per year. If inflation is 2%, your real return gets reduced to 6%. This yield could be even lower if the fund has a high total expense ratio, too!
The second factor that affects return is risk. All assets have some degree of uncertainty that they’ll go down in value and result in a loss. But, not all assets have equal amounts of risk.
The key to getting a good return is risk management. It’s crucial to understand the assets that you buy and their potential downfalls. This helps you to find a balance between the risk you are taking and the expected return that you’ll receive.
Some people assume that they should only be concerned with growth. But, there’s more to investing than gains and getting a good return.
Investments have risks and are often unpredictable. The expectations we have for them doesn’t always match what happens in reality.
Therefore, it’s important to find balance in the risk-return trade-off. This investment principle states that the larger the risk you take, the more money you need to receive in return.
Assets with the least amount of risk get called risk free. They’re guaranteed and have almost no chance of the principal getting lost.
Yet, they’re still subject to some types of risk. These include interest rate risk and opportunity cost. A few examples of risk-free investments are US government debt, savings accounts, and CDs.
Today, most of these assets produce less than a 1% return. They earn less than inflation and result in negative real returns!
Investors want to earn a good return. So, they buy assets that have more risk. Their money gets exposed to greater uncertainty and they expect to get compensated for it.
How would you react to a small loss? What about a big one?
Higher risk doesn’t always equate to better returns. It usually means there is a higher chance the investment will underperform or that you may lose all or part of your principal.
As you age, your risk profile will change. Most investors start off willing to take larger risks and earn greater returns. But as time progresses, they get closer to financial freedom and have less time to recover from downturns. As a result, they want less uncertainty and more predictability.
Also, your risk vs reward tradeoff gets based on your knowledge and comfort level with the assets you’re buying. Making it important that you understand them and the expected returns they produce.
Low-risk assets are considered stable and safe. Their principal is often guaranteed, but they have low returns.
As investors seek greater returns, they buy assets that have more risk. Their money gets exposed to larger uncertainty and they expect to receive a risk premium in return. This is extra compensation that’s above and beyond what risk-free assets offer.
But, investors looking for a good return must be realistic. They need to consider current and historical returns to determine what yields they’ll likely earn.
Below are a few asset types and their expected returns.
A bad return on investment generates profits that are lower than your expectations. While a good return produces earnings that meet or beat your prediction. And sometimes you earn the best returns on the assets that you decided not to buy!
When it comes to investing, past performance is never a guarantee of future results. Rarely do assets perform at their averages. Most will have periods of fluctuation where they’ll either outperform or underperform. But over time, most will return close to their average.
How do these returns compare to yours? Are they higher, lower, or about the same?
If your yield is near or above these, then you’re getting a good return! If you aren’t, then you need to re-evaluate your financial position. Find out where your returns are lagging, what you can do better, and make some changes!
Investments are unique. They offer various risks, which generates different returns.
The assets you buy and the yield they produce determines the amount of money you need to save and invest. This in turn affects the amount of time it takes for you to save and reach your financial goals.
For example, imagine your goal is to generate $40k in income per year. Using the expected returns from above; you could save and invest $5 million in a savings account, $4 million in CDs, $727k in bonds, or just $444k in stocks!
But, having all of your investment capital in one asset class is another type of risk. It’s called unsystematic risk and gets reduced through diversification.
There are even more things you can do to increase your likelihood of investment success, too.
You save to invest, so that your money will grow. The higher your return, the faster it compounds, and the larger it becomes. This increases your financial wellbeing and pushes you closer to financial freedom!
The best way to earn a good return is to buy assets that you understand and hold them long term. These assets will fluctuate in value, but over time most will perform close to their average.
A good return is different for everyone. But, yours should beat inflation, get based on risk vs reward, and help you reach your financial goals faster!
What do you consider a good return on your money? Comment below.
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