Monday, January 15, 2007

What Investment Return Should We Target? (Part 2 of a five-part series)

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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

24 Comments:

Anonymous MrParkerBohn gmail said...

In my opinion, people usually have unrealistic expectations about future returns from investments. They tend to draw a line from recent performance through the sky.

The author here has used 15 years of data in order to compare various asset classes. Let me present longer-term data for the stock market alone. Using data from Dr Shiller's website and US government sources, I've calculated:

That the total return to the S&P (dividends re-invested) from 1900-2004 was 9.6% annually.

Here are the components of that return:

1) 5.2% was from capital gains.
2) 4.4% was from dividends.

However, inflation was 3.1% annually during this period.
Also, P/E's expanded by 0.6% annually during this period.

Discounting inflation and assuming that P/E's don't expand forever, we are left with about a 6% return.

Unless you have some reason to believe otherwise, don't assume that the stock market will beat inflation by over 6%. When planning anything important like
retirement, it would be safer to assume a lower return, such as 4-5% over
inflation.

Remember, this data reflects a century of unprecedented success that made the USA the richest country in the world. If this does not continue, returns may be
lower.

4:23 PM, August 22, 2007  
Anonymous Anonymous said...

Questions:
(1) What is the definition of assets bubble?
(2) What are the root causes of assets bubble build up?
(3) What are the signs or indicators signal assets have reached to a bubbly level?
(4) What normally trigger asset bubble burst? Can you share your perspectives based on case studies of dot.com, Japanese stock market crash in 90s, recent American housing problems, potential Chinese market crash, etc.
(5) What percentage of cash should one hold to take advantage of major market corrections or market crash?
(6) What is your definition of risks?
(7) How do you value closed-end funds? How do one knows the NAV is rational though underlying market securities might trading at discount?
(8) Do you believe in Efficient Market Theory?
(9) What are the advantages and disadvantages of being a retail investor?
(10) Are fund size closely correlated with returns?

10:06 AM, September 08, 2007  
Anonymous Mutual Fund Online said...

Nice Blog. :)

2:03 AM, April 30, 2010  
Anonymous Inventory POS System said...

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4:07 AM, December 29, 2010  
Anonymous Mutual Funds said...

Inflation is increasing at such a rate that it will be difficult for stock market to beat inflation.

3:36 AM, January 14, 2011  
Anonymous Anonymous said...

I like the 20% target, but that's pretty much served up in a vacuum. Any stock can go up 20%; any stock can go down 20%. If you buy a stock at $10 hoping to sell at $12, are you going to hold it when it drops to $9? What happens if it stays at $9? I find that very few people consider the impact of taking losses. There's just this latent assumption that everything is going to go up, and your portfolio's going to compound at 10% annually regardless of market factors.

7:51 AM, January 27, 2011  
Anonymous triple net lease properties said...

If you're getting into real estate, cash flow is one word that you'll be hearing a lot of. It's one of the most important considerations investors face when making their real estate purchases.

7:57 PM, February 13, 2011  
Anonymous Anonymous said...

Re: Anonymous' many Questions. What is the purpose of the many Questions?

1:52 AM, February 21, 2011  
Anonymous Anonymous said...

Ha! I thought so. The purpose was to get some unsuspecting Anonymous to ask what the purpose of the Questions was. Or were? :^)

1:56 AM, February 21, 2011  
Anonymous triple net lease properties said...

Great post. We have finally found one source of information that is both valuable and easily applicable for our future investment decisions.

11:49 PM, March 09, 2011  
Anonymous Mutual fund said...

what do you think about mutual funds?

10:52 PM, June 09, 2011  
Anonymous Best Mutual Fund said...

Mutual Funds are good place to park your money for a longer period of time, and are more safer than stocks.

4:18 AM, June 22, 2011  
Anonymous Business Plan Writers said...

This post is awesome..we've been reading tons of crap posts from other blogs, but shows you have a more educated reader base.

11:34 PM, April 03, 2012  
Anonymous Basith said...

Its really simple. There is no need to decipher graphs and lot of reports.Only thing you need to do is ask for the best MF and invest in SIPS.Dont even thinking of withdrawing in less than 5 years. You are bound to get around 20% for more than 10 years(in India)
Fintotal - Finance for non-finance people

5:30 AM, September 18, 2012  
Anonymous Mobile Marketing said...

These type of schemes are all just bubbly... I've never heard someone who claim to become rich with that business.

2:57 AM, November 13, 2012  
Anonymous Online PMP Exam prep said...

If they really earn much money then they would not need to convince people to believe them...people will if they really are.

6:52 AM, November 13, 2012  
Anonymous Res Course said...

You can know the investment return we should target. Good post

10:20 PM, December 17, 2012  
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