Most invest with one goal in mind: to make money. You invest to build wealth to be able to do the things you want to do. What you invest in will determine, largely, how much money your investment earns, so it’s good to understand how much you need, what to invest in, and what kind of a return you can expect. We have answered some of the most common questions regarding this topic.
What does Return on Investment mean?
Return on investment, or ROI, is a profitability ratio used to measure the amount of return, or profit, an investment generates relative to what you paid for it. ROI is written as a percentage and is used to evaluate individual investments; it is very useful when comparing one type of investment with another.
What you invest in matters.
The biggest determinant of return is the type of investment you select.
Below is a table that shows the compounded annual growth rates (CAGR), which are simple rates of return that assume all profits, including dividends, are reinvested for several types of investments (“classes”).
|Asset Type||Compound Annual Growth Rate (CAGR)|
|Certificates of Deposit||1.0%|
DATA SOURCE: MORNINGSTAR
As you can see, there is a very large difference between investing in small-cap stocks and Treasury bonds. The primary reason for this difference is the risk associated with each investment; small-cap stocks are far riskier than Treasuries. Remember: high-risk, high-return; low-risk, low-return.
Return vs risk.
Generally, the higher the potential return of an investment, the higher the risk. There is no guarantee that you will actually get a higher return by accepting more risk.
If you are only willing to accept the risk associated with a Certificate of Deposit (relatively little risk of losing your money), then you cannot expect anything but low returns. Bonds, thought to be a relatively safe investment, carry more risks than Certificates of Deposit. Today, the Federal Reserve is raising interest rates to hedge inflation, and this action is causing most bonds to lose value. Stocks carry an even higher risk, because you have the potential of losing some or all of your money. If you invest in a company that goes bankrupt, you lose; there are no safety nets. Most recently, investors have jumped on the Bitcoin wagon, perhaps one of the riskiest investments available. They are willing to take on this risk for the potential reward of becoming rich (which is very unlikely).
Additionally, it is also important to think about how long you plan to keep the money invested, how your investment options have performed historically and how inflation could impact your return. There are several ways to reduce your investment risk, as well, like diversifying your portfolio over all asset classes and holding your investments for a long time.
How much return do I need?
If you wish to grow your wealth, you must earn a return greater than inflation and the cost of the investment. Historically, inflation runs about 3% in the U.S.; if you are earning this or less, you are not keeping up with the cost of goods, let alone building wealth. If the investment cost you 1% to purchase, you need to factor that in, too. In this case, you would need an investment that historically returns more than 4%, so this might be a corporate or other bond. Most investors aren’t satisfied with this kind of minimum return, so they add stocks to their portfolio. Again, even this might not produce the return they hope to get, but at least they have that potential over time.
The younger you are, the more risk you can take, because you have more time to earn it back. In this case, you might find an investment portfolio comprised of 80% stocks and 20% bonds. However, most elderly investors aren’t willing to lose some or all their money in stock investments because they may not have time to recover from a loss. In this case, you would expect to see a portfolio comprised of 20% – 40% stocks and the remainder in bonds.
This is why high inflation is so damaging to retirees on a fixed income. A portfolio of bonds won’t provide the purchasing power compared to a portfolio of stocks. But for most retirees, they don’t want to take on the risk of owning more stocks. This is when a good financial advisor can be very helpful!
Even if math isn’t your favorite subject, it’s quite simple to calculate a return on your investment. Here’s the formula:
ROI = (Ending value of investment – Initial value (cost) of investment) / Initial value (cost) of investment X 100
The resulting answer is then expressed as a percentage.
Let’s do an example problem to help you understand.
Let’s say you invest $10,000 in a stock at the beginning of the year and at the end of the year your investment is now worth $11,000. Simply plug in the values and use a calculator to solve for ROI.
ROI = ($11,000 – $10,000) / $10,000 = 0.1 X 100 = 10%
Based on the historical data on stock market returns, this investment would have achieved an expected annual return of 10%, a good ROI.
Return on investment, or ROI, can vary greatly between what you need, what you expect, and what you get. It depends mostly on the risk an investor is willing to take.
A young family who wants to send their children to college and retire comfortably must take on more risk than a retired couple. Because the market doesn’t move upward in a straight line, the young family expects to earn a return some years and lose money in others; however, over time, they build wealth and are able to achieve their financial goals. The financial goal of most retirees is to not run out of money in retirement. Their portfolio looks different than the young family’s because they are not willing to assume all that risk at their age. They will not earn the same returns on their investment, nor should they expect to.