Your Investment Returns Depend on Your Comfort with Risk

To reach financial goals such as paying for college tuition or a comfortable retirement, you will need to determine the amount you need to invest using a reasonable rate of return on your investments.

“ Individuals often ask what they can expect to make on their investments,” says Pat Swanson, CFP® and families specialist with Iowa State University (ISU) Extension’s Invest Wisely Project (www.extension.iastate.edu/investwisely).  “That answer depends of which of the three major investment categories – cash, bond or stocks we’re talking about.” 

The potential return on an investment can be current income (such as interest, dividends, or rent) and/or capital gains or loss (the change in the value of the investment during the time the investment is held).  The combination of income and capital gains is the total return from an investment.  You can calculate the rate of return by dividing the total return by the amount invested and then annualizing this return for one year.

Historically, cash as measured by short-term Treasury bills earned an average of 3.7 percent compounded annually during the period of 1926 through 2006.  Long-term government bonds earned 5.4 percent, while long-term corporate bonds earned an annual return of 5.9 percent.

Returns from stocks, including reinvestment of dividends, averaged 10.4 percent a year during this same period for large company stocks (stocks in the S&P 500).  Small company stocks, which are riskier historically, have earned 12.7 percent.  During this same time period, inflation averaged 3.0 percent annually. 

However, just because something has performed a certain way in the past doesn’t mean it will continue to do so. Swanson reminds investors to be realistic when figuring a return.  “If an asset class has averaged 10 percent, it is not realistic to assume you will earn this return every year.  These are averages and there can be considerable variations in any one year.”

Swanson cites the example that large company stocks lost 22 percent in 2002, followed by a gain of almost 29 percent in 2003, 11 percent in 2004, 5 percent in 2005, and 16 percent in 2006.  “The longer the time period for which you are investing, the closer the return will be to historical averages, but remember, it’s still an average.”

Also, keep in mind that individual assets in a category may not perform at the average.  “While small company stocks as a group have realized the largest return over the years, not all small stocks have achieved this return.  Many small stocks have earned more than the average while many have earned considerably less or have even lost,” Swanson says.

“All investments involve risk,” Swanson cautions.  “It is important to balance the amount of risk you’re willing to take with the return you are aiming for.  The higher the potential return on an investment, the higher the risk.” 

For example, Treasury bills have the least risk while small company stocks have considerably more risk.  If you are unwilling to assume the risk associated with a particular investment category, then you may have to lower your expected return.  To compensate for a lower return, you can start investing earlier to reach a targeted goal or invest a larger amount.  For example, $100 deposited monthly over a 20 year period will result in almost $76,600 if you earn a return of 10 percent.  To achieve this same amount if you earn a return of 6 percent, you would have to invest more than $160 a month for the same number of years.

Swanson concludes, “If you keep your goals in mind and decide what level of risk you’re comfortable with, you can determine how much you need to invest for what time period.”

Investment experts also warn against offers that seem too good to be true. “Don’t forget the first rule of finance: The higher the reward, the higher the risk. In today’s market there’s no such thing as a guaranteed 10 or 15 percent return,” according to Craig A. Goettsch, director of Investor Education for the Iowa Insurance Division. “Con artists prey on people who rely on safe and predictable income from bank accounts, money market funds and dividends, promising them a high but safe return. Over the years we have seen frauds involving promised safe or guaranteed returns from things like promissory notes, prime bank instruments and leaseback arrangements. Investors are attracted to this type of investment because it has an aura of safety with a higher-than-market rate of return."

The ISU Extension Invest Wisely Project provides a series of newspaper, radio, and web resources for investors.  It is funded by a grant from the Investor Protection Trust (IPT).  The IPT is a nonprofit organization devoted to investor education.  Since 1993 the IPT has worked with the States to provide the independent, objective investor education needed by all Americans to make informed investment decisions.  www.investorprotection.org.