What is a Good Return on Investment?
Keep reality in mind when looking for good returns.
Some would say that 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 occur 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 a good return on investment, investors have to keep a realistic idea of what is a win.
If you don’t know what is realistic than any con artist can convince you that they have something special. The people who fall victim to scams are the ones who believe that outsized returns are possible. Let’s take a look at 6 broad categories of investments and the returns you might expect.
1. Speculative Investments
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 breakthrough and our investment would easily double in value. Over the next 2 years, I lost 90% of my investment. Luckily, I didn’t invest very much because I knew it was speculative.
Don't be fooled. Even legit companies offering stock can be speculative. Small biotech companies whose sole purpose is to find the next breakthrough treatment could rise or fall by 80% or more in a single day based on ab FDA ruling.
Sure, you could find yourself on the right side of that move but you could also lose nearly everything. The same could be said for new IPOs and stocks purchased solely because they look like a takeover target.
Gold is another example of something that might fall into the speculative category. If you get the timing right and catch gold before a crisis, you might make a fortune.
In that case, you'd think gold was the best investment ever - but really what happened is you got lucky and your speculative investment happened to pay off.
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 were a gold investor during that time period you probably didn't think it was so great. If you’re thinking about investing in gold, do it as part of a diversified portfolio.
2. 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 versus investing in a stock index fund. I use an investment risk scale of one to five, with five representing a high-risk choice, and one having the least amount of risk. 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.
Safe investments like savings accounts are given a risk level of one.
3. Real Estate
Real estate is something you often see promoted as providing an excellent return on investment. Does it? Well, it can, if you know what you are doing. Many wealthy folks made their fortune by investing in real estate. Real estate can also, like any investment that provides the potential for good returns, result in a loss. Although there are plenty of Realtors looking to sell you real estate, the truth is that real estate is for advanced investors who have spent years or decades in these markets. Rental properties or home flipping is not an easy way to make money until you have plenty of experience.
And as we saw in the Great Recession of 2008, even purchasing a home, like so many Americans do, represents risk.
4. 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%.
With bonds, 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. If you own an individual bond and planning on holding it to maturity than these price fluctuations won't impact you.
The lates speculative craze? Bitcoin and other cryptocurrencies. Whether or not cryptocurrency represents the future of financial transactions is the subject of much debate but seasoned investors know that when something rises as fast as Bitcoin did in 2017, the risk of losing big outweighs the possible rewards of scoring the big win.
If you invested in Bitcoin years ago when the general public didn't know it existed, congratulations on your win but getting in after the big move isn't good risk management.
6. Safe Investments
Safe investments are the one option that can provide a return on 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.
Never follow the fads.