Compounding interest feels like magic, when you see your money grow every year. If you 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! If, instead, you invested 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 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. You've set it aside for education, retirement, buying a house, or 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.
Value investing helps you 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 simple. Your price plus ten percent of your price equals $1100. $1100 is 110% of your price. Divide $1100 by 110% (divide by 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.
Investment Returns Must Beat Inflation
Prices tend to rise over time. 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 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 2% or 3% a year—much less so since the 2008 financial crisis, but it's a good rule of thumb.
You must understand the implications for your investments.. 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 losing you money—it's losing you buying power. For example, if you need $1000 a month to pay your expenses now and you 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. A good annual return on stocks beats inflation and taxes and builds real wealth for you.
As an aside, you should expect 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, however.
Investment Returns Must Beat Taxes
Like inflation, 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. 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.
Suppose you've invested $1000. In two years, you sell the investment for $1500 (great job!). You've made $500 in profit, or an amazing 50% return. 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.
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.
Average ROI versus Good ROI
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. 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, and that's the goal. Anyone promising a reliable and higher investment return is taking big risks. 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.
The average return on investment for most investors may be, sadly, much lower. 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 has 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.
8% is a good ROI benchmark. 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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