For a long time after the 2008 financial crisis, interest rates in banks, CDs, money market accounts, et cetera were terrible. If you could get over 1% return, you'd feel lucky. Things have changed in the 2020s after the Covid-19 pandemic, especially as the US Federal Reserve began raising interest rates. As of this writing in April 2023, you can get over 3% returns for a very short term deposit and closer to 5% on longer term deposits. The world has changed!
Compounding interest feels like magic especially when your money grows every year. If you invest $1000 at 5% simple interest, you'll have $1750 in 15 years. That's $750 in interest. If, instead, you invest at 5% annual compound interest, 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 5%, what if you could get an 8% interest rate? 10%?
Contrarily, what if you put all of your money in high-interest savings accounts and earned 3%? The efficiency of that investment is a lot less than 8%, even if the difference between 3 and 8 doesn't seem that high every year.
Why does this matter? This is your money. Maybe you've set it aside for education, retirement, or buying a house. That money is leverage; it buys you freedom.
Stocks, Bonds, Real Estate, and Mutual Funds All Have Different Returns
Different types of investments have different returns. Many of these differences depend on the investments themselves.
For example, you might see a real estate holding grow in value at 6% year over year. Consider, though, that there's a fixed supply of real estate, and that not all parcels of land are the same. Would you want to trade an acre of land in Death Valley, California for an acre of land in downtown San Francisco? (Probably, but who would be on the opposite side of that trade?)
Or consider a bond that gives you a reliable payout every quarter compared to a stock that pays no dividend. One may be more valuable than the other depending on your financial position. It's important to know what your goals are and why you're investing in one thing versus another to evaluate if the return and the time to return make sense in your situation.
It's also important to be aware of market conditions. In the past couple of years, buying bonds or Treasury bills could have been a poor investment as the prime rate increased, because the face value of the bonds decreased. On the other hand, buying land might have been a good investment as the desire for more housing increased. Do your homework as always!
Everything You Need to Know About Your Effective Rate of Return
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.
This is especially important for retirement planning; the earlier you start, the more a high return will pay off. The less time you have before you want to retire, the higher return you need.
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 simple. Your price plus ten percent returns equals $1100. $1100 is 110% of your price. Divide $1100 by 110% (divide by 1.1) and you get $1000. This means you must pay no more than $1000 right now to get a 10% return when you sell.
How do you calculate that 10%?
Suppose you've invested $1000. In two years, you sell the investment for $1500 (great job!). You've made $500 in profit as an amazing 50% return. Take 15% of that away (don't forget the taxes you pay; $75 in long terms capital gains here), 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 38.8% return after two years is still great, but it's a lot less than the $1500/50% you had when you started.
(That 38.8% return means your money multiplies by 2 every 4 years. That's amazing!)
The annual rate of return on an investment is the profit you make on that investment in a year. For every dollar you invest, how much do you get every year in return?
The simple way to calculate this value is to look at a simple percentage. You invested $100 and made $3, so your return is $3/$100 or 3%.
Remember the inflation, fees, and taxes picture you face. Factor them in. Depending on your investment goal and timeline, you'd like to know what a hypothetical million dollars will buy you in 10, 20, or 40 years.
A good annual return on stocks beats inflation and taxes and builds your wealth.
Investment Returns Must Beat Inflation
You know what taxes and fees are. What's inflation?
Prices tend to rise over time. Maybe you have a cable bill that keeps going up, or you remember when milk and gasoline both cost less than $2 per gallon. There are many economic reasons why prices rise gradually over time. This is normal economics.
Inflation means that, over time, a dollar is worth a little bit less. Inflation has traditionally been about 2% or 3% a year—much less so since the 2008 financial crisis, but it's a good rule of thumb.
The operative word here is "time". 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 your investment grows more slowly than inflation, you're losing money because your buying power is decreasing. For example, if you need $1000 a month to pay your expenses now and think those expenses will rise to $1200 when you retire, you'll need to make $1200 a month to pay your bills. Assuming inflation is between 2 and 3% annually, any investment that earns you money over the long term must make at least 3% a year just to break even.
Remember that the relationship between the inflation rate and the stock market is complicated. The market as a whole should match or exceed inflation every year. All those price increases have to go somewhere. That's no guarantee for every individual stock or the market as a whole in any given year, however.
Investment Returns Must Beat Taxes
Taxes are as inevitable as inflation. When you sell most kinds of investments, you'll have to pay taxes on any profit. 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. To calculate your effective rate of return—how your invested money is actually growing—you must factor in taxes. If, for example, you are 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.
You can delay taxes (invest pre-tax income in something like an employer-sponsored 401(k) or a 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.
Investment Returns Must Beat Fees
You're probably paying broker fees for every transaction. If you're investing in funds instead of stocks, you may be paying additional fees. In particular, mutual funds tend to have higher fees than ETFs. If an average fund return on investment is 5% annually and you're paying 2% in fees, you're only getting a 3% return and you need to look elsewhere.
If you're paying no fees for an ETF and you've only paid $4-10 dollars commission for the purchase and the same for the sale, you're already way ahead of investing in funds.
Compare ROI to Find Great, not Average, Investments
ROI, or Return on Investment, measures the efficiency of an investment. For every dollar you put in, what kind of profit can you expect?
Use this ROI percentage to compare investments—even if they're not otherwise similar. For example, buying a blue chip stock that raises its dividend every year is different from buying a small cap stock that invests its revenue in growth. The risk profiles for these companies are different. The research you need to do is different between them. Yet comparing only ROI can give you a sense of where you want to focus.
Furthermore, 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 a 7-10% return every year over the past 50 or 60 years. If that's enough, buy it. Otherwise, you need to find a better investment.
The average return on investment for most investors may be, sadly, much lower, even 2-3%. Putting your money in a bank account will give you a negative return, after taxes and inflation. So will a CD or a money market account. Investing in Treasury Bills may let you avoid taxes, but in the past few years they've underperformed inflation.
Even the most conservative, tax-free investment strategy of buying municipal bonds can get you 4% tax free every year (depending on whether you pay state or local taxes on your returns). That's 1-2% after inflation—a mediocre return, all things considered, but very conservative. You'll double your money in 35-72 years. You can do better.
Maybe 10% is your goal, but can you do 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 taxes, you'll end up with 11.6% return.)
Remember, this rule of thumb applies whether you're investing in real estate, savings accounts, mutual funds, or even long-term life insurance. Factor in what you want to make, account for fees and taxes, and then work backwards.
Investment Returns and Personal Finance
Of course, this means nothing if you're investing money you'd otherwise be using to pay off credit cards. The best credit card rates are going to be at least 16% annually, so you'll have to make at least that after taxes and inflation to come out ahead.
Your best personal finance move is to pay off any personal loans, credit cards, or other debt which holds an interest rate higher than your expected investment returns. You won't have to pay any taxes on this, and you'll be improving your monthly cash flow.
With everything else equal, paying of a loan with a 10% APR is better than getting 10% on an investment with the same money. Consider that before you sink all your available cash into stocks or funds.
Active ROI Targets for Value Investors
Value investing helps you find good opportunities. The best way to make money in the stock market is to buy good investments at great prices and sell at a profit. Figuring out the right price for a stock requires you to know how much you want to earn when you sell it.
A really good return on investment for an active investor is 15% annually. It's aggressive, but it's achievable if you put in time to look for bargains. You can double your buying power 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. That's your goal. If you look at the raw data for the average rate of return for the stock market, you'll see 7% as a lower bound. Some decades are much better. Some are much worse.
For any individual investment, you should also look at average returns. For example, the S&P 500 average return can swing wildly from year to year; if you invested on January 1, 2022 and took your profits or losses on December 31, 2022, you'd have lost 18%. The year before, you'd have gained 28.47%. Check the historical average returns to estimate your potential returns and measure risk and likelihood of any wild swings.
Anyone promising a reliable and higher investment return is taking big risks. No reputable investment advisor will stand behind this word. The best investment returns do take on risk, but repeatability is more important over the long term than one huge winning streak followed by mediocre or terrible performance.
Use a benchmark of 8% for a good stock ROI. This is a good way to objectively assess the potential profitability of your investments. Putting your money in a simple index fund and letting it grow will return you an average 8-10% 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 at least that. Settle for nothing less.
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