We’ve all heard the stories of investors who’ve doubled, tripled, or even 10X their money. However, incredibly high rates of return are nearly always coupled with uncomfortable levels of risk and the prospect of losing every dollar invested.
Unfortunately for many people, chasing after fantastic returns like these results in little more than gambling. But it doesn’t need to be this way.
There are far better ways to increase your net worth without taking on fanatical levels of risk. Gradual investing in a retirement or brokerage account for years or even decades is how regular working people with modest salaries eventually retire as millionaires.
So what exactly makes for a good rate of return? A responsible answer will depend on many individual factors such as your investment goals, risk tolerance, and what you’re putting your money into. Here’s what you’ll need to need to know.
What is a Safe Rate of Return?
The first place to start is by understanding what a safe return rate is. A “safe” return rate is the amount of money you’ll be paid for investing in something that carries virtually no risk. These are generally financial instruments that pay a pre-determined amount of interest such as:
- A high-yield savings account with an online bank or financial institution
- Certificates of deposit (CDs) from your bank or credit union
- Government bonds
- Etc.
The rate of these assets is connected to something called the federal funds rate. This is the interest rate set by the U.S. Federal Reserve. Each time the Fed meets, they decide if interest rates will go up, down, or stay the same based on the latest economic data.
Since the Fed began raising interest rates in 2022, it’s now possible to open a 12-month CD and receive as much as a 5% APR. That’s $50 a year for every $1,000 invested. And unless the bank goes under, you can be sure to get your initial capital back.
However, in the decade leading up to the COVID pandemic, interest rates were not so good. The federal funds rate was near zero for many years, and as a result, most banks paid less than 1% on CDs and bank accounts. This led many people to turn to riskier investments like stocks.
What’s the Average Return of the Stock Market?
When talking about stocks, it’s helpful to generalize their performance by looking at something called a benchmark. A benchmark is a group of companies whose stock prices are regularly tracked and averaged together. Analysts can then use these benchmarks to make comparisons and draw conclusions about other stocks and funds.
One of the most widely followed benchmarks is the S&P 500. This is a group of the 500 top-performing U.S. companies. Investors can buy what’s known as an index fund which replicates the performance of this benchmark. Not only does nearly every major financial institution offer some version of this index fund, but there are also several ETFs (exchange-traded funds) that can bought to accomplish the same goal.
Historically, the S&P 500 has returned an approximate average annualized rate of 10 percent. However, what’s important to keep in mind is that this is a long-term average. Some years the stock market declines and returns are negative. That means if someone had to sell their shares for whatever reason, then they would take a loss.
If you don’t sleep well at night knowing that your investment might lose money, then stocks may not be a good choice for you. You can easily get a feel for how little or how much the markets lost or gained by looking at the historical average returns over 5, 10, and 15-year periods.
An S&P 500 index fund is one out of thousands of possible funds investors can choose from. Each carries its own risk and return possibilities, and investors can combine them in various ways to strengthen the possibilities (an advanced concept known as Modern Portfolio Theory).
What’s the Average Rate of Inflation?
Anyone who’s bought anything in the past two years understands very well what inflation is. Inflation is the natural tendency of prices to rise over time.
Generally speaking, as production and material expenses increase over time, so do the market costs to consumers. However, these prices can also be swayed by many other economic factors such as demand, supply, interest rates, employment stats, etc. One of the main jobs of the Federal Reserve is to make adjustments to the American monetary policy to keep inflation at a target of 2 percent.
Similar to the stock market, inflation rates change all the time and can be much higher than the Fed’s target. However, if you were to take the average annualized rate over several decades, then the trend would be between 3 and 4 percent.
When investing, it’s important to consider inflation because it’s constantly working against you. As the purchasing power of your money erodes, the rate of return you may be achieving won’t look as good. Therefore, to put future figures into today’s dollars, we have to subtract the inflation rate from our investment growth to truly understand the “real” rate of return.
Putting It Altogether – What is a Reasonable Rate of Return?
Now that you know the three main elements to consider, you can put it all together as follows:
Risk-Adjusted Rate of Return – Inflation = Real Rate of Return
Where:
- Risk-Adjusted Rate of Return – This is the rate you can expect to earn depending on how much risk you’d like to take. If you’re more conservative, then lean towards the risk-free rate. If you’re open to some volatility in hopes of a better return, then use the rate of an index fund. If you’re somewhere in between, then use a number somewhere in the middle of these two values.
- Inflation – An average rate somewhere between 3 and 4 percent is realistic.
- Real Rate of Return – This is how much you can expect your portfolio to grow with the same purchasing power as today.
For example, let’s say you’re relatively young and investing for retirement. Since retirement may be several decades away, you’ve got plenty of opportunities to invest more aggressively in high-growth potential assets. Therefore, a reasonable rate of return would be:
10% – 3% = 7%
By contrast, let’s say you’ve got some money that you’ve been saving up as the down payment on a house. Even though you’d like that money to grow, you certainly can’t afford to risk losing that money to a dip in the stock market. In that case, you’d want to invest safely in something like a 12-month CD paying an APR of 5.0%.
5% – 3% = 2%
Even though the CD will pay you 5%, in reality, a dollar won’t buy as much a year from now as it can right now. So your actual rate of return would be closer to 2%.
The Bottom Line
No matter what rate of return you’re hoping to achieve, what’s important is that you define your goals and determine your risk tolerance. Those two factors alone will shape the type of returns you can expect to receive.
Beyond that, the main ingredient to successful investing is to keep making regular contributions. Whether the market is up or down, you should consistently be putting money into your account and buying up assets. This will help you to naturally take advantage of an age-old practice of dollar cost averaging.
If you’re not contributing as much as you’d like, then take a good look at your budget. Review your last three to six months of transactions and determine where you may be getting off track. The sooner you start putting your money to work in the places you want it to, the closer to financial freedom you’ll be.
Featured image credit: Unsplash
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