Higher-risk investments must offer higher returns to justify their risk. This is why savings accounts pay only about 1% or less in interest per year, while returns on other investments can be ten times that or more.
However, novice investors often make the mistake of chasing unrealistic rates of return without understanding the crucial relationship between risk and return.
Risk, Volatility, and Their Measurement
Investment risk refers to the possibility that you end up with less money than you originally had.
For instance, when you buy a bond, you’re essentially lending money to the issuer of the bond. You expect a return on that loan, which is the interest rate the bond pays. However, there’s a risk that the company or government that owes you the money might not be able to pay you back.
If you bought a 1,000𝑏𝑜𝑛𝑑𝑏𝑢𝑡𝑡ℎ𝑒𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑟𝑜𝑛𝑙𝑦𝑝𝑎𝑦𝑠𝑦𝑜𝑢𝑏𝑎𝑐𝑘750 and then becomes unable to make further payments, you’ve lost $250, not to mention the returns you were expecting.
Investors are willing to take on risk because it’s why they can expect returns. Investors also need to be compensated for the volatility of their investments.
When you buy a stock of a company, the price you pay is what the stock is worth at that moment. The stock market is open five days a week, and every second the market is open, people are buying and selling stocks.
The stock you bought could be sold seconds after you buy it. A week or two later, its value could be half or double what you paid for it. Although the entire market has steadily risen over the past century, we can pinpoint factors that cause stocks to rise and fall over the long term—but trying to predict short-term stock prices is nearly impossible.
How much the value of an investment can change in a short period, and how unpredictable its direction of change is, that’s what we call the volatility of an investment.
Investments with higher volatility require a higher return to justify their volatility.
So, What Is a Good Investment Return?
Since investment returns depend on their risk and volatility, a good return on investment is one that exceeds the returns required by its risk and volatility. To understand the return an investment needs to justify its risk and volatility, you need to compare it to similar investments.
If every savings account in the world pays an interest rate of 1%, and you find an account that pays 1.2%, then that account offers the highest investment return rate. We can say this confidently because you’re getting an additional 0.2% return without taking on any additional risk or volatility.
Seeking Alpha
In the investment field, when considering risk, alpha and beta are used to measure investment returns.
Alpha (α) measures the ratio of investment returns to its risk and volatility. The formula for calculating alpha is:
α = Actual Return – (Risk-Free Rate + (Overall Market Return – Risk-Free Rate) Beta)
The risk-free rate refers to the return you could get from an investment with no risk at all. Typically, U.S. investors use the return of three-month Treasury bills as the risk-free rate.
A positive Alpha value indicates that considering the risk and volatility of your investment, you’ve received a higher return than expected. A negative Alpha value indicates that considering the risk you’ve taken on, your return is below what it should be.
To calculate alpha, you need to know the beta of your investment.
Beta (β) is an indicator of an investment’s volatility. It’s calculated using complex regression analysis. A beta value of 1 indicates that the stock’s volatility is exactly the same as the whole market. The higher the beta value, the greater the volatility; the lower the beta value, the lesser the volatility.
Average Returns of Different Asset Types
Different categories of assets, stocks, bonds, precious metals, real estate, etc., all carry different risks. Since the inherent risk of these investments is well-known, certain parts of investing have become common knowledge.
Stock investments offer higher returns but carry greater risk, while bond yields are slow and steady.
So, what constitutes a good rate of return? 54.2% is the historical highest annual return rate for the stock market, 32.6% for bonds, and 27.6% for real estate. However, by the definition of a year’s historical high, this should be viewed as an unsustainable upper limit of investment return rates.
Achieving Higher Investment Returns
One investment you can truly enhance returns on by getting your hands dirty is real estate. If you’re willing to refurbish a fixer-upper yourself, you can flip the house for a substantial profit or rent it out for much more than the monthly mortgage payment.
You could also buy homes in neighborhoods that are currently lackluster or rundown but are on the rise or likely to rise soon (though investing in less pleasant neighborhoods is another example where taking on greater risk might mean higher returns…but also more hassle). If you keep a house in an emerging neighborhood in good condition, once the area improves and property values go up, you can sell it for a significant profit.
How Fees Affect Your Returns
One thing to be mindful of when trying to achieve as high a return as possible is how fees can impact your returns. Even if you manage to beat the market by 1% consistently, if your transaction costs and expenses total 1.5% of your investment, you’re actually losing money.
The hefty fees charged by asset management firms make it harder for them to deliver substantial returns to you, as they must beat the market by a certain percentage each year just to cover their fees.
This example will illustrate the effect of fees over time. If you invest 10,000𝑤𝑖𝑡ℎ𝑎10174,494.02. Add a modest fee of 0.5%, and your balance becomes 152,203.13.𝑇ℎ𝑎𝑡′𝑠𝑜𝑣𝑒𝑟20,000 less.
Finding low-fee investment options is as important as finding investments that offer good returns. Choosing one of the best online stock brokers is crucial.