Compounding interest feels like magic, when you see your money grow every year. If you invest $1000 at 5% simple interest for 15 years, you'll end up with the $1000 principal plus $750 in interest. That's $1750 altogether. If, instead, you invested at 5% compound interest (compounded annually), you'll have about $2079. Compounded monthly, you'll have about $2114.
The real magic comes when you earn a higher rate of return on your investment. Instead of investing at 5%, what if you could invest at 8%? 10%? Throw in compounding, and you'll see your money grow.
Why Does Annual Rate of Return Matter For Investing in Stocks?
This is not an abstract calculation. This is your money. This is the money you're setting aside for an education, for retirement, for buying a house, or for whatever purpose you decide. That money is leverage; it buys you freedom.
After you choose your investing goals, you will have a target in mind. You know how much money and time you have to invest. You know the finish line. You have enough information to calculate what gets you from here to there. The magic of time and compounding interest will help, if you understand it.
The goal of value investing is to find good opportunities. The best way to make money in the stock market is to buy good stock investments at great prices and sell later for more than you paid. Figuring out the right price for a stock requires you to know how much you want to earn when you sell it.
If you can sell something next year for $1100 and want to make a 10% profit on it, what should you pay for it now? The math is pretty simple. Your price plus ten percent of your price equals $1100. $1100 is 110% of your price. Divide $1100 by 110% (or 1.1) and you get $1000. In other words, you want to pay a maximum of $1000 right now to get a 10% return when you sell it.
How do you calculate that 10%? That's a good question.
Why Does Inflation Matter?
Prices tend to rise over time, as you've noticed. Maybe you have a cable bill that keeps going up, or you remember when milk cost less than $2 per gallon. There are many economic reasons why prices rise gradually over time, but in short, this is a normal economic phenomenon.
Inflation is the means by which, over time, a dollar will be worth a little bit less every year. As a rule of thumb, inflation has traditionally been about 3% a year—much less so since the 2008 financial crisis, but it's a good rule anyhow.
This has tremendous implications for your investments. You must understand this. If you're saving for retirement in 20 or 30 years, inflation will work against you. A million dollars is a lot of money, but it won't buy as much in 20 or 30 years as it will today. (It would have bought a lot more 20 or 30 years ago too.)
If an investment earns you less than the rate of inflation every year, your investment is costing you money. (Technically, it's losing you buying power, but the difference is subtle and irrelevant to this example.) Thus any investment that earns you money over the long term must make at least 3% a year just to break even. If you're looking for the best return on investment, you have to account for that 3% one way or another. A good annual return on stocks beats inflation and taxes and builds real wealth for you.
Why and When Do Taxes Matter?
Inflation is almost inevitable. Taxes are inevitable. When you sell most kinds of investments, you'll have to pay taxes on the profit you've made. The specific taxes you will pay depends on the type of investment, how long you held it, your other income, and where you live. For more details, either do the boring research yourself or consult a tax professional.
The broad implication is similar to inflation, however. If you want to calculate your effective rate of return, remember to factor in taxes. If, for example, you are is subject to US capital gains taxes, figure that you'll pay 15% taxes on the profit of any investment you sell (if you hold it for at least a year). The resulting amount is your effective profit.
To put everything together, suppose you've invested $1000. In two years, you sell the investment for $1500 (great job!). You've made $500 in profit. Take 15% of that away (you pay $75 in capital gains taxes), so you're left with 1475. That's a 47.5% return in two years. Not bad! Now account for two years of 3% inflation, and you end up with $1388. That's still not shabby (38.8% return after two years), but it's a lot less than the $1500 you had when you started.
There are ways to delay taxes (invest pre-tax income in something like an employer-sponsored 401(k) or an SEP, in the theory that your marginal tax rate will be lower in the future than it is now) or avoid taxes (invest post-tax income in a Roth IRA and avoid paying any taxes on gains in the future), but the government will eventually get its due. Plan for it.
What is a Good Return on Investment?
Your target rate of return determines which opportunities make sense for you—if you can't buy a stock at the right price, move on and find something better. Assume that the S&P 500 has given an 8-10% annual return amortized over time over the past 50 or 60 years, you're looking for an investment which will beat that. 10% is your goal, but you can do better. How about 12%, after taxes and inflation? (A high rate of return, of course, will beat that, but you'll have to work for it.)
Assume that inflation is an annual 3% and capital gains are 15%. If your target is a 15% return before inflation and taxes, you'll end up with 12.4% return. (If you pay 20% in capital gains taxes, you'll end up with 11.6% return.)
A really good return on investment for an active investor is 15% annually. That's healthy. That's reasonable. (It's aggressive, but it's achievable if you put in time to look for bargains.) You can double your money every six years if you make an average return on investment of 12% after taxes and inflation every year.
More importantly, you can beat the market at that rate, and that's the goal.
A good ROI to use as a benchmark is 8%. Putting your money in a simple index fund and letting it grow will get you a pretty consistent 8-10% return over the long term, if the market continues to behave as it has for the past several decades. If you're going through the work of choosing your own investments, you deserve to make more than that. And you can. Good investments are available.
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