I’ve heard it said a good return on investment is the return of your investment. There is a tremendous amount of wisdom in that statement. The biggest investing mistakes I have seen all occurred when someone took bigger risks in the hopes of earning better returns, and instead ended up losing most of what they had.
In order to determine what is a good return on investment you have to know what is realistic. If you don’t know what is realistic than any con artist can convince you that they have something special. I have seen people conned over and over by someone promising them an outstanding return on their investment; something in the 20% or higher range for example. Earning returns like this is about as common as winning the lottery. Let’s take a look at a few broad categories of investments and the returns you might expect.
Let’s start with rule number one: the higher the potential return, the greater the risk. Penny stocks make a great example. I bought a penny stock once. It was recommended by a friend, someone I had known for years. He said he had done all of his due diligence and the company was poised for a giant break-through, and our investment should easily double in value. Over the following two years, I lost 90% of my investment. Luckily, I didn’t invest very much because I knew it was speculative.
Gold is another example of something I think falls in the speculative category. If you get the timing right, and catch gold before a crisis, you might make a fortune. Get the timing wrong and you can watch your investment go through a long and steady decline in value, which is what happened to the price of gold from 1980 when it hit $850 an ounce to 2001 when it went under $300 an ounce; a loss of 65% of its value. If you’re thinking about investing in gold, do it as part of a diversified portfolio. Additional details can be found in Is Gold a Good Investment.
Traditional Stocks and Stock Funds
What about blue chip stocks or the stock market as a whole? In order to evaluate returns on this type of investment you have to understand the difference in the level of risk you take when investing in a stock verses investing in a stock index fund. On my investment risk scale I classify investing in a single stock as a level five investment risk: you can lose all your money. I classify a stock index fund as a level four risk; you can lose money but it would be near impossible for you to lose all your money.
You can see historical stock market returns in this set of market return graphs. Over short periods of times stocks can provide a single year return on investment as high as 97% or a loss of -42%(as measured by the Russell 2000 Index for small cap stocks). Over twenty years, if you held onto an S&P 500 stock index fund, annualized returns have been as high as 18% a year, or as low as 7% a year, depending on the twenty year time period you were invested.
Real estate is one option that you often see promoted as providing an excellent return on investment. Does it? Well, it can, if you know what you are doing. It can also, like any investment that provides the potential for good returns, result in a loss. You need to do a considerable amount of learning before you buy a rental property or invest in any form of real estate. I’d suggest you start with John T. Reed’s book How to Get Started in Real Estate Investment. I provide additional thoughts on real estate in Is Real Estate a Good Investment.
Traditional Bonds and Bond Funds
When I say traditional bond, I mean government or corporate issued bonds that have a rating of Baa3(Moody’s), BBB-(S&P/Fitch) or higher. I classify these types of bonds in the level two or three risk category on the investment risk scale. You can see bond index returns in the dark green, blue and yellow colors in this rolling returns series of graphs, with long term government bonds having their highest twelve month return of 54% and their lowest of -17%.One thing to keep in mind about bonds is that their principal value goes down when interest rates rise. This has a greater effect on long term bonds and a lesser effect on short term bonds.
Safe investments are the one option that can provide a return of your investment, although they may not provide a good return on your investment. Historical returns on safe investments tend to fall in the 3 to 5% range, but are currently much lower as they primarily depend on interest rates. When interest rates are low, safe investments deliver lower returns. This situation can cause people to chase riskier investments with the goal of earning higher returns.
What About The Great Return Stories?
What about the stories you hear about people earning spectacular returns by finding the right stock? That’s called luck. Some people win the lottery too, and we’re happy for them, but we don’t go around investing all our money in lottery tickets, do we? It is absurd that just because one person may have made a good return on a stock or real estate investment, that you would think it is easy to duplicate the results. It’s about as easy as winning the lottery.