Interestingly, and not surprisingly, less experienced groups of investors (for example, young investors just beginning to invest) tend to have higher and more unrealistic return expectations. In this chapter, I reveal and discuss the actual returns you can reasonably expect from common investments. I also illustrate the power of compounding those returns over the years and decades ahead, and I show you why you won’t need superhuman returns to accomplish your personal and financial goals.
Estimating Your Investments’ Returns
When examining expected investment returns, you have to be careful because you’re largely using historic returns as a guide. Using history to predict the future, especially the near future, is dangerous. History may repeat itself, but not always in exactly the same fashion and not necessarily when you expect it to.
Money market funds and savings account returns
Be sure to keep your extra cash that awaits investment (or an emergency) in a safe place, preferably one that doesn’t get hammered by the sea of changes in the financial markets. By default, and for convenience, many people keep their extra cash in a bank savings account, which tends to pay relatively low rates of interest. Banks accounts come with Federal Deposit Insurance Corporation (FDIC) backing, which costs the bank some money.
Another place to keep your liquid savings is a money market mutual fund. These funds are the safest types of mutual funds around and, for all intents and purposes, comparable to a bank savings account’s safety. Technically, money market mutual funds don’t carry FDIC insurance. To date, however, only one money market fund has lost money for retail shareholders (and in that case, it amounted to less than 1 percent). Bank account depositors have lost money, by the way, when they had more than the insured amount (currently $250,000) in a bank that failed. When a bank fails, it’s typically merged into a financially healthy bank and those who had more than the insured limit at the failed bank generally take a haircut.
If you don’t need immediate access to your money, consider using Treasury bills (T-bills) or bank certificates of deposit (CDs), which are usually issued by banks for terms such as 3, 6, or 12 months. The drawback to T-bills and bank certificates of deposit is that you generally incur a transaction fee (with T-bills) or a penalty (with CDs) if you withdraw your investment before the T-bill matures or the CD’s term expires. If you can let your money sit for the full term, you can generally earn more in CDs and T-bills than in a bank savings account. Rates vary by bank, however, so be sure to shop around.
Bond returns
When you purchase a bond, you should earn a higher yield than you can with a money market or savings account. You’re taking more risk because some bond issuers (such as corporations) aren’t always able to fully pay back all that they borrow.
By investing in a bond (at least when it’s originally issued), you’re effectively lending your money to the issuer of that bond (borrower), which is generally the federal government or a corporation, for a specific period of time. Companies can and do go bankrupt, in which case you may lose some or all of your investment. Government debt can go into default as well. You should get paid in the form of a higher yield for taking on more risk when you buy bonds that have a lower credit rating. (See Chapter 9 for more information on bonds, including how to invest in a diversified portfolio of relatively safe bonds.)
Jeremy Siegel, who is a professor of finance at the Wharton School at the University of Pennsylvania, has tracked the performance of bonds (and stocks) for more than two centuries! His research has found that bond investors generally earn about 4 to 5 percent per year on average, which works out to about 2 to 3 percent per year above the rate of inflation.
Consider a government bond that was issued at an interest rate of 4 percent when inflation was running at just 2 percent. Thus, an investor in that bond was able to enjoy a 2 percent return after inflation, or what’s known as the real return — real meaning after inflation is subtracted. Now, if inflation jumps to, say, 6 percent per year, why would folks want to buy your crummy 4 percent bond? They wouldn’t unless the price drops enough to raise the effective yield higher.
Longer-term bonds generally yield more than shorter-term bonds because they’re considered to be riskier due to the longer period until they pay back their principal. What are the risks of holding a bond for more years? There’s more time for the credit quality of the bond to deteriorate (and for the bond to default), and there’s also more time for inflation to come back and erode the purchasing power of the bond.
Stock returns
The long-term returns from stocks that investors have enjoyed, and continue to enjoy, have been remarkably constant from one generation to the next. Since 1802, the U.S. stock market has returned an annual average of about 9+ percent per year, or in other words about 6 to 7 percent per year above the rate of inflation. That’s a remarkable track record, but don’t forget that it’s an annual average return.
Now some people think that a 9 percent annual average return doesn’t sound like much. But at that rate of return, an investment will double in value every eight years.
Stocks have significant downdrafts and can easily drop 10, 20, or 30 or more percent in relatively short periods of time. Stocks can also rise dramatically in value over short periods. The keys to making money in stocks are to be diversified, to invest consistently, and to own stocks over the long run.
Stocks exist worldwide, of course, not just in the United States. When investing in stocks, go global for diversification purposes. Diversified portfolios of international stocks have produced annual returns comparable to those generated by U.S. stocks.
International (non-U.S.) stocks don’t always move in tandem with U.S. stocks. As a result, overseas stocks help diversify your portfolio. Thus, in addition to enabling U.S. investors to diversify, investing overseas has proven to be profitable over the years and decades.
Chasing after specific stocks or sectors that have recently been hot: Yes, what a rich genius you’d have been if you’d invested in Apple stock (or Chipotle, Google, McDonald’s, Amazon, Ulta Beauty, or Facebook) when it went public. With the benefit of hindsight, it’s easy to spot the “best” stock