This is a contribution by Troy, blogger behind The Financial Economist.
What are Realistic Investment Returns?
In these days when Bernake rules supreme, the average citizens of the world are left with two choices. Either we can invest in bonds that yield an unbelievably awesome 2% a year, or we can invest our own money and make a meager 12% in this bull market. Tough choice, eh?
Such an obvious choice is what draws so many new investors to the market – the chance to make some real money in this next-to-nothing interest rates environment. Unfortunately, too many investors approach this game with the mindset of a gambler – I’ll be real angry if I don’t AT LEAST double my money this year! Of course, you ask these guys how they know how they can make such pathetic returns, and they’ll say “I can just feel it in my bones!”
Now you may be laughing at this, but this is a far too plausible scenario. Too many investors jump right on-board the Investment Train without knowing that this train often runs parallel to the edge of the Rocky Mountains. So what kind of returns can an individual investor realistically expect?
Like everything in the world of investing, there is no clear-cut answer.
It depends on a couple of factors:
- The markets you invest in.
- How long you have been investing.
- Your investment style.
- Your time frame.
- Your financial products.
But of course, for every market whose realistic investment returns are higher, the potential losses are also higher (higher risk, higher reward) – just keep that in mind.
Return Factor #1
What market you invest in – stocks, bonds, currencies, commodities, etc – will play a big role in deciding how much you can realistically make. The big mistake a lot of investors make is that they expect to make 40% a year with stocks – this just ain’t going to happen. Compared to a lot of other markets, stocks are a rather “flat” market, meaning that the volatility isn’t exactly insane.
A big year for stocks might be a 25% move, whereas bonds and commodities can make the same jump in a month. Realistically speaking, good stock market investors can make an average of 25% a year, nothing close to the amazing returns you hear from hedge funds.
If you’re going to invest in bonds, then the returns are pretty obvious – 2% a year. However, if you’re trading bonds, then that’s a whole different story. Bond trading, not to be confused with bond investing, can be highly profitable. A 1% move coupled with a bit of leverage yields magical returns, to the tune of 50% a year that some bond traders are making. Of course, inexperienced bond traders should not even hope to make such returns – the bond markets are such dangerous markets (trading-wise) that most traders would be lucky just to break even.
Currencies, as I mentioned in my post about volatile markets, are an extremely volatile market because all traders (there are no investors) who trade currencies do so with leverage. However, even with leverage (realistically speaking) you are not likely to make more than 40% a year, even if you’re a good currency trader.
This is because currencies usually have really small price movements, something along the lines of 4 – 5% a month. In addition, a lot of currencies such as the CAD/USD pair trade in ranges, making the formation of large trends unlikely. Although the currency markets aren’t big on returns, but their extremely big on size.
Contrary to popular belief, currency trading isn’t attractive because of it’s supposedly “massive” returns but because it is the one market where the big market players can easily move in and out of the markets without their own buying/selling pushing the markets (hence the massive liquidity).
Commodities are a frequently overlooked market. Although commodities such as crude and gold have historically underperformed stocks, that “history” only goes back to the 1970s Nixon took us off the gold standard. Gold and oil have experienced massive bull markets, and are poised to continue to do so in a world where emerging countries are eating up what’s left of the earth’s resources.
I personally know a couple of commodity investors are doing extremely well – one can expect to make more than 60% in good years (as in 2010), but of course that includes heavy downswings. But all in all, commodities have drastically outperformed stocks in the last 10 years because historically raw material prices have been suppressed by increases in agricultural efficiency..
Return Factor #2
The second factor is pretty obvious – the longer you’ve been around the markets, the more experience you probably have had which hopefully translates into making fewer mistakes. New investors shouldn’t expect to shoot the lights out the first year – my first year of investing wasn’t exactly a honeymoon either. The first year should be a time of learning, which means that you will make plenty of mistakes that should be corrected in the future.
Investing is difficult, especially if you’re new to the game. First you have to learn all the jargon, and then you can start learning how to invest. Age in the markets doesn’t necessarily guarantee wisdom nor investment success, but inexperience CERTAINLY won’t. That’s why they say that investing is an old man’s game.
Return Factor #3
Are you an aggressive investor who’s ok with participating in massively volatile markets? Or are one of those investors who will buy more as the market falls?
Investors who are more laid back and less concerned with the short-term market situation obviously cannot expect such great returns – they cannot beat the market’s average of 8% per annum by a significant amount. On the other hand, the best and most profitable investors are always the more aggressive ones who, like the Big Swinging Dicks & Dickettes (see Michael Lewis’ famous book Liar’s Poker), have the guts to bet big and be nimble.
Return Factor #4
A major component that decides your investment style is your time frame – are you a short-term trader, a medium term investor, or a long-term investor?
As I’ve already mentioned, long-term investors should not expect the kind of returns that great traders can generate. Good long-term investors can probably make 15% a year, provided that they catch the right side of long-term bull/bear markets and keep buying on the dips, whereas a lot of traders can realistically say that their goal is to make 70% a year.
One caveat I’d like to add: even though the best investors are the more active and aggressive ones, as a whole the long-term investors outperform the aggressive investors, whose average investment returns are dragged down by some major losers (high returns, high risk!).
Return Factor #5
Last but not least, the financial products that you choose to invest in also determine realistically how much returns you can make. You’ve probably got not clue what a financial product is.
A financial product is simply how you choose to express an investment idea. For example, let’s assume that you’re bullish on U.S. companies. One way of expressing this opinion is to outright buy stocks, maybe even a U.S. large-cap index fund. More arcane ways of expressing this idea can be by buying a call option, which is the right (but not the obligation) to buy a certain stock in the future at today’s price.
Inherent in different types of financial products are their expected returns. By outright buying or selling stocks, you can maybe expect 15% per year. However, other financial products like options or futures are more of an all-or-nothing investment (or gamble, whichever way you want to see it) – you can either double your money, or lose 60% in two weeks.
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