What Investment Return Should We Target? (Part 2 of a five-part series)
Being successful in passive wealth generation involves setting realistic targets that are consistent with inherent market risk. You might want to become a millionaire, centi-millionaire or even join the rarified ranks of the world's billionaires, but if you try to get there too hastily, you'll in all likelihood never even reach your first financial milepost.
Get Rich Quick?
We've all received "invitations" (translation: advertisements) complete with "complimentary VIP tickets" to attend "once-in-a-lifetime financial conferences" that promise to teach the "secrets" of how to "buy real estate at 40% to 60% below fair market value," earn 1000% and higher annual returns buying and selling stock options, or retire in a couple of years with additional cash flow of $9,000 per month. Such get-rich-quick schemes are tantalizing for the ambitious novice investor. However, since I have never run across anyone who has succeeded in making money through these programs, I am skeptical. I tend to believe that the schemes generally turn out to be losing propositions for those gullible enough to pay thousands of dollars in seminar fees to fast-talking finanacial "coaches" offering hope but ultimately little more than what amounts to an express route to the poorhouse.
At iamfacingforeclosure.com you can follow the latest developments in a timely and well-publicized case in point, about a guy who paid to attend a few real estate seminars and attempted to implement the "no money down" techniques he heard about. Unfortunately, instead of getting rich, he ended up losing substantially more than he invested. In his own words, "I made some mistakes and fell flat on my face with millions in debt and [am now] facing foreclosure." In fact, the poor chap's financial circumstances have become so dire that he is also considering bankruptcy. Obviously, this is hardly a pleasant outcome for someone so energetic and driven as he appears to be.
(By the way, if anyone reading this knows of a wealth generation program that actually does consistently achieve returns in excess of, say, 20% per annum, I would be very pleased if you could share information about the program and provide a detailed investment track record for everyone's perusal.)
Rather than greedily go "elephant hunting" for enormous returns using unproven wealth generation techniques whose effectiveness is, at best, very difficult to verify, I recommend following a more predictable course to which we now turn.
Historical Market Returns
Let's look at the historical record to get a feel for what type of investment returns are possible across commonly accessible financial markets. The bar graph below shows the annual performance of cash, bonds, stocks and real estate over the 15-year period from 1992 through 2006, based on historical market data from Global Financial Data and the Office of Federal Housing Enterprise Oversight.
(Click graph to enlarge)
- Cash: Money market accounts, bank CDs and Treasury bills offer comparable rates for holding cash. The 3-month Treasury bill averaged a 4% annual yield over the 15-year period.
- Bonds: The 10-year Treasury bond showed a 5% average yield. Bond returns vary with changes in interest rates; however, over long holding periods, yield becomes a good proxy for approximating annual investment return for bonds.
- U.S. Stocks: The S&P 500 stock index has given a 10% average annual return over 15 years, with annual performance ranging from -23% in the worst year (2002) to +34% in the best year (1995).
- Foreign Stocks: U.K. stocks (FTSE) averaged an 8% annual return (U.S. dollar-based), similar to the performance of the U.S. stock market during the same period. Impacted by a lengthy recession during the 1990s, Japanese stocks (Nikkei 225) averaged just a 2% annual return (U.S. dollar-based) with considerable volatility, returning -35% in the worst year (2000) following a +51% rise in the best year (1999).
- U.S. Real Estate: The median value of single-family homes sold across the U.S. has appreciated 6% on average over the past 15 years, including the annual double-digit gains during the recent real estate boom that now appears to have ended.
Gold, other commodities, options and futures, collectibles, etc., are also possible investment vehicles. However, broadly speaking, these alternative investments tend to offer average multi-year returns similar in magnitude to the equity-related (i.e., stocks and real estate) returns discussed above.
Targeting Realistic Returns
For passive wealth generation, what then is an appropriate target to set for annual investment returns?
Even though the past 15 years are not necessarily a reliable indicator of the financial market performance that will actually transpire over the upcoming 15 years, we can use the historical record to help set reasonable expectations for the future. First of all, if, among the three stock markets (U.S., U.K. and Japanese) surveyed above for the 15-year period 1992-2006, the best year in the best market produced a 51% return, it is clearly unreasonable to expect to achieve in any consistent way returns higher than this level. In particular, a rational investor should be highly skeptical when hearing anyone claim to have a scheme that can consistently achieve anything like the 1000% returns touted by certain get-rich-quick seminars.
Next, we must decide the extent of risk we are comfortable taking on to achieve higher investment returns. A conservative, risk-averse investor will want to allocate assets primarily to bonds and cash, which can be expected to produce 3% to 6% annual returns. Investors seeking higher returns will want to weight their investment portfolios more heavily towards equities. In fact, given that equities have historically outperformed bonds and cash, I would recommend that anyone with a long-term investment horizon should seriously consider owning as close as possible to 100% equities, allocating only a minimal amount of one's portfolio to cash for liquidity purposes.
Given that the S&P 500 has averaged about a 10% return over the past 15 years, it is reasonable to target similar returns for an equity-based investment program over the next 15 years. Specifically, here's what I recommend:
- Look for investments that can produce 20% annual returns, while realistically expecting 10% average annual returns and understanding that somewhat lower 5% average annual returns might actually result.
In my opinion, anyone "reaching out" for annual returns substantially higher than 20% is speculating more than investing. Of course, speculators do occasionally hit the jackpot, but the hard truth of the matter is: people who choose to speculate rather than invest are generally setting themselves up for predictable financial failure rather than measured financial success.
Next week: Buying equities