Of course, we're all looking for a good return on investment when we invest our money, but what is considered a good return on investment? There are many types of investments and many investment goals. Defining what a good return is for you will depend on the type of investment you're most comfortable with, what your short-term and long-term goals are, and the amount of risk you are willing to take.
Risk vs. reward
Generally speaking, the rate of return from an investment is related to the amount of risk involved. Typically, higher-risk investments have a higher rate of return, while safer investments will provide a lower return.
This is similar to how a bank lends money. People with excellent credit get the lowest interest rates because they're less of a risk to the bank. People with poor credit scores pay the highest interest rates because the bank wants a higher return for taking the risk of lending to somebody with a lower credit score.
In most cases, when an investor is simply trying to park their money and protect it from inflation, they are comfortable with a lower rate of return because they want to minimize their risk as much as they can. On the other hand, investors who want higher returns to grow their wealth are willing to take on more risk in exchange for that potential reward.
Passive vs. active investments
The rate of return an investment can provide often depends on the amount of effort you have to put into the investment. Some investments only require you to put your money in and sit back while it grows. Other investments take work to maintain. For instance, a rental property can provide a nice return on your investment, but it also requires you to be actively involved. A mutual fund, on the other hand, likely won't provide as high of a return but doesn't require any work on your end.
Just as the level of risk is related to the rate of return you'll receive on your investment, the amount of effort you have to put into the investment is also related to the returns you can expect.
Choose your investment goals
To determine what a good return on investment is, you first have to know what your investment goals are.
When speaking with Larry Mengerink, Investment Executive with Park Lake Advisors, about common investment goals, he said, "Many times, the goal is centered around wanting to retire or save for a child's college education. These aren't short-term goals. They're more of an idea of something they would like to do sometime in the distant future."
Many people also have investment goals centered around earning extra income or building wealth.
Whatever you're investing for, Mengerink offers advice, saying, "Be specific. What is the purpose of the goal? Why is it important to you? What are you using as a barometer to decide if you're on-target or you've achieved your goal? One of the toughest parts is making sure that your goal is achievable. It's easy to have a pie-in-the-sky goal, but it's critical that you stay grounded with your goals."
Investors who are mostly focused on long-term investment goals tend to choose investments that don't involve much risk. The lower returns work for them because they continue to accumulate over several years. Investors with a goal of building wealth sooner are typically more comfortable with the higher-risk investments because those will provide the potential for the highest return on investment.
Types of investments
While there is an endless number of different types of investments available, this article will focus on some of the most common types of investments that you may be considering.
Owning real estate
There are various types of real estate investments you can get into. The type of real estate investment you choose will depend on your investment goals, the amount of capital you have available, and the amount of effort you're willing to put into the investment.
Some common types of real estate investments include:
- Single-family rentals.
- Small multifamily (1-4 units).
- Multifamily (5+ units).
- Assisted living.
- Multi-tenant office building.
- Single-tenant office building.
- Multi-tenant retail.
- Single-tenant net lease retail.
- Mobile home parks.
While you may hear people argue that real estate generates passive income, in reality, real estate investing requires the investor to play an active role. Even when there is a property manager involved, the investor still has to make decisions about the property and often times has to write checks to cover repairs or capital expenditures (money spent buying, maintaining, and improving properties). Treating real estate as a truly passive investment is likely to result in your investment losing money over time.
One of the major benefits of real estate investing is the ability to finance your purchase. Depending on the property, some banks may let the investor borrow up to 80% of the purchase price. This allows an investor to buy an investment property with less capital as well as profit from the equity gained as the principal balance is paid down. This leverage helps provide a good return on investment.
Real estate investment risks
The level of risk in real estate investing varies greatly depending on your investment model, the types of properties you're investing in, and whether you're financing the purchase. High vacancy or expensive repairs can result in investing more money into the property to keep it afloat. Real estate is also difficult to liquidate. There are significant expenses involved in selling a property, and it may take a long time to find a buyer.
Real estate investment returns
Whichever type of real estate you're investing in, there are three basic ways you can receive a return on your investment:
- Cash flow: Income from rent collected.
- Appreciation: Increase in value.
- Equity build-up: From decreasing principal balance on a mortgage.
The return on investment with real estate can be calculated a number of ways and depends on whether the property was financed or purchased with cash. With real estate, it's impossible to accurately predict what return, if any, will be achieved through appreciation. Instead, investors will look at the rate of return based on the total purchase price of the property, the rate of return on the cash they put in as a down payment (cash-on-cash), and the equity build.
Lower-risk investments in commercial real estate tend to yield a return somewhere between 6% and 8% from cash flow. Properties with this type of return are typically available on the market and can be purchased without too much difficulty.
Higher-risk real estate investments that have a "value-add" component to them can have a potential return of 10% to 12% from cash flow. This type of investment typically requires a considerable amount of effort in locating the right deal, making repairs, and putting in new management.
The return from cash flow is an average annual return. To figure in the additional return you would receive from the equity build would require knowing how long you intend to hold the property. The longer you hold the property, the faster the equity starts to build as the amount of principal owed on the property decreases.
Investing in individual stocks has been one of the most common ways people have invested and built wealth for over 100 years. When investing in stocks, you are purchasing a share of a company and betting on that company being profitable and increasing in value.
Depending on your investment strategy, investing in stocks can be a passive or active investment. If you plan to watch the market closely to buy and sell as values fluctuate from one day to the next, this type of investment will likely be the most time consuming of all investments. On the other hand, if you are investing in stocks for the long-term growth of the companies you invest in, it can be a more passive investment.
Stock investing risks
The level of risk involved with investing in stocks varies greatly depending on the types of companies you are investing in. Some stock purchases carry a high level of risk with potentially higher return, while other stocks carry much less risk and are likely to steadily increase in value over time.
Stock investment returns
Investors earn a return on their investment through stocks in two ways:
- Dividends: Share of the company's profits.
- Capital gains: Selling stocks for more than you paid for them.
The annual return from stocks can vary greatly from one year to the next, but investors often turn to historical data to determine what to expect as an average annual return. For instance, over the past 30 years, the S&P 500 index has had an annual return as high as 34% and has lost as much as 38%. However, the average annual return the past 30 years for this index is 9%. That is a very good return on investment, but it requires an investor to be able to ride out some really tough waves.
When investing in bonds, you're basically lending money to the bond issuer, then receiving interest payments over the term of the bond. At the end of the term, you are paid back the principal amount you invested. Bonds can also be sold to other investors during the term of the bond. If interest rates go down, your bond will increase in value since other investors will want the higher interest. Similarly, if interest rates rise, the value of your bonds will decline since investors can get higher interest rates from newer bonds.
Investors usually purchase bonds for the predictable and consistent interest received every year. If your strategy is to buy and hold bonds, then it is a very passive investment. On the other hand, if your plan is to time the market as interest rates change, it can become a fairly active investment.
Bond market risks
The investment returns on bonds depend on the credit rating of the issuer. Treasury-bonds are issued directly from the federal government and carry almost zero risk but don't offer as high of an interest rate as other bonds. Corporate bonds, on the other hand, have a higher level of risk so they pay higher interest rates. Since different corporations have different credit ratings, the risks and potential earnings can vary greatly. If the issuer of the bond defaults, the bond is basically worthless.
Bond investment returns
Bonds provide a return in two ways:
- Interest: Investors earn passive income from the interest paid by the issuer over the term of the bond.
- Capital gains: If the bond increases in value due to credit rating or interest rate changes, investors can profit from selling their bonds for a higher price than they purchased them for.
The return on investment from bonds depends on the type of bonds and the length of the term. Bonds with a long term may provide a return of 8% but may require as long as 30 years to have your principal returned. Treasury bonds and shorter-term bonds are more commonly in the 4% to 6% annual return range.
When you invest in a mutual fund, you are pooling your money together with other investors and allowing experts to pick and choose which securities to buy and sell. Some mutual funds invest in a broad range of stocks and bonds while others, known as index funds, will match a specific market index.
As a mutual fund profits from the investments it makes, it pays dividends out to its investors. Many mutual funds offer investors the option of having the dividends paid to them directly for passive income or to have them reinvested in the fund. Since the fund managers take on the task of managing the investments, mutual funds are a passive investment.
Mutual fund risks
Since they are managed by market experts, and they typically have a well-balanced portfolio, most mutual funds are considered a safe investment. The average annual return on a mutual fund is usually pretty consistent and predictable. This doesn't mean that there are zero risks with mutual funds, as they can still be greatly affected by a sudden stock market crash.
Mutual fund investment returns
Investors earn profits from mutual funds in three ways:
- Dividends: Shares of a company's profit and interest from bonds.
- Capital gains: Profits from stocks or bonds the fund sells.
- Net Asset Value (NAV): An increase in the value of the investor's mutual fund shares.
Since mutual funds are typically used for long-term investments, investors will often look at how they expect a mutual fund to perform over the length of time they plan on holding their investment. Mutual funds will normally show you their historic returns for one year, three years, five years, 10 years, and 20 years. This data helps determine which mutual funds will provide a good return on investment.
You can typically expect a return of around 4% to 5% with mutual funds that are heavily invested in bonds. Mutual funds with a higher level of risk that are invested more heavily in stocks can provide returns of as much as 8% to 10% but will be more volatile.
Real estate investment trusts (REITs)
A REIT is a fund that can be bought and sold like stocks and uses a pool of funds from investors to invest in real estate. REITs have three major benefits:
- The security of real estate.
- The liquidity of the stock market.
- The professional management of mutual funds.
REITs are a passive investment, since you aren't involved in the management of the properties or in their purchase and sale. Investors should keep an eye on the real estate market, however, to be aware of changes in values of the types of properties the REIT they are invested in owns.
REITs carry a moderate level of risk. They are backed by the value of the real estate they own, which does offer some protection to their value. The risk involved with REITs is that their value depends on the real estate market. If the value of the types of properties they are invested in declines, the value of the REIT may be more likely to decline as well.
REIT investment returns
REITs primarily earn a return on investment in three ways:
- Rental income: REITs earn a profit from leasing property to tenants, just like other real estate investors do. This is the primary source of revenue for most REITs.
- Capital gains: When a REIT sells any of its assets for a profit, it earns a profit from the capital gains of the sale.
- Loan interest: If the REIT invests in mortgages, it will earn profit in the form of interest on the loans.
The majority of income earned through a REIT is from its operating income. This comes from the profits earned through the rent collected. A large portion of the return on investment earned from REITs is through the dividends they pay. Dividends from a REIT are typically higher than stocks, which makes them attractive to some investors.
The average rate of return on a REIT depends on the real estate sector it is invested in. Over the past 15 years, the average rate of return has ranged from 9% to 14%. However, the actual return from one year to the next is very unpredictable. In the same 15 years, there have been years with losses of over 20% and gains of 50%. While the overall average return is excellent, you have to time your exit very carefully.
What is a good return on investment for you?
Deciding what a good return on investment is for yourself will depend on the level of risk you are willing to take and the amount of effort you want to put into your investments. When you decide what type of investment is right for you, you should compare the expected return on the particular investment you're looking at to the average returns in that type of investment.
You should also consider the deadline for your goals. If you have an end date in mind, you can time real estate investments to be able to cash out on all of the equity at the end. On the other hand, to time the exit so that you don't suffer any losses, REITs and stocks may require a larger window of time.
If you want a good return on investment, limit your risk to what you can afford to lose and stick to the plan that aligns with your goals. Keep a close eye on your investments, and compare how they're performing against other similar investments. As you get closer to achieving your final goals, you may want to adjust your strategy some to reduce your risk and protect the returns you've worked for.
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