The return of investment (ROI) is a financial metric that describes the efficiency of an investment in comparison to its cost. The ROI is given as a percentage rate and becomes useful when comparing the profitability of one investment with different others.
The return of investment can be calculated by dividing the investment gain by the investment cost:
The ROI should be important to any investor since it is crucial to know how much return an investment can make in comparison to other investment opportunities. But what can be considered a good ROI?
What Is a Good ROI?
Technically speaking, the higher the ROI the better. But in reality, it is difficult to find investments that have an increased ROI, without facing a higher risk that comes along with the investment. Risk plays a vital role in the assessment of a good investment because it generally correlates with the return. Usually, the higher the potential return of an investment, the higher the risk.
This is why a high potential ROI on its own doesn’t necessarily indicate a good investment. You may come across an investment that has an uncommonly high ROI but the question is how likely are you going to make a consistent amount of profit from that investment, or in other words, how likely are you going to lose the money that you invest in that asset?
A suitable investment can be defined differently for each person. Younger investors who still have a long investment horizon to come, are generally able to take a higher level of risk since they’ll have a sustained time period to recover from possible losses.
On the other hand, investors who are planning on retiring soon shouldn’t necessarily pick any investments with higher risk factors, as their investment time frame may not be long enough to recover from a potential severe loss.
Therefore, using the ROI as a metric for comparison only makes most sense if you are fully aware of the risk level that lies behind each investment which you are about to make.
Average ROI of Different Asset Classes
Investment returns can heavily differ from one asset to another. This is primarily due to the risk level that comes with each investment.
Stocks for example, generally perform better and thus have a higher return than bonds since most fixed-income securities tend to come with a lower level of risk for the investor. Here are the historical average returns of the most common asset classes:
Source: JPM Guide to the Markets
Stocks & Equity
When it comes to measuring the average stock market returns, most investors look at the S&P 500, a stock index that consists of 500 big companies listed on stock exchanges within the United States. The purpose of this index is to measure the general performance of U.S stocks. That’s why the S&P 500 also acts as a benchmark of the market’s average return.
The average annual return of the S&P 500 since 1926 is considered at about 10%. Since 1957, when the index fully tracked 500 stocks, the average return has been at around 8%.
Please note that the average return of the stock market can vary with each year. You shouldn’t expect an exact return of 10% every single year. Sometimes, stocks can far outreach this number and bring much greater returns in a given year, while heavily underperforming the average return in another.
However, if you invest in stocks for a long time frame, you can expect your average annual return of all the following years to come close to that average percentage level.
Fixed Income & Bonds
Bonds allow investors to invest money for a fixed interest rate and thus, generally offer a reliable and consistent cash stream. While there are several different types of bonds, yielding different levels of return, they tend to come with a lower return than stocks.
That doesn’t necessarily mean that you should not invest in bonds. Bonds offer a lot of benefits and can be a suitable investment for people who would rather receive a consistent income from their financial securities. This can be ideal for people who prefer a safer place to invest their wealth such as investors with a shorter investment horizon. On top of that, bonds act for many investors as additional diversification within portfolios.
There are many types of bonds ranging from sovereign bonds issued by national governments that come with the lowest amount of risk since governments can always print money to assure guaranteed repayments but also provide the lowest return, up to high-yield bonds that usually offer the highest yield in accordance with a high risk of default, which is the failure to repay the debt to the investor.
Real-Estate-Investment-Trust (REITs)
Real estate investment trusts or REITs are usually less popular than stocks but have proven to provide a greater return than the average stock market. REITs are companies that solely own and manage real estate properties which provide a high level of income stream. A big proportion of business income is then directly being paid out to the owners as dividends.
According to the MSCI U.S. REIT Index, the average 10-year performance of REITs sits at around 13%. This makes REITs one of the best performing asset classes. That being said, the best performing asset doesn’t necessarily mean the best for everyone to invest in.
As it is with most other asset classes, usually a higher average return of an asset comes along with a higher level of risk. This is no different for REITs. Even if they do provide a steady income stream like bonds, they mostly do carry a great level of risk.
Conclusion
As an investor, you have many different options to build massive wealth over the long term. A good investment return is essentially one that is as high and consistent as possible over a long period of time. What kind of return you should aim for, completely depends on your personal circumstances.
Here are some of the questions you should be asking yourself to assess your current situation for your most suitable investment strategy.
How high is your risk tolerance? How patient do you consider yourself and how long do you want to stay invested? Do you prefer your money to be stored safely and grow steadily, or are you looking for the highest possible return? Do you need to rely on your invested capital? How much time and effort are you willing to spend on investing?
Note that each percentage point of the return does in fact matter and can make an enormous difference in the resulting profit within the long run. Any investment that provides a return lower than inflation, is not considered a good long term investment, as its real value will diminish over time.
That being said, one key thing to always consider with each investment decision is the risk factor. The risk that comes with each investment should play an equally important besides the actual return of the investment and should always be minimized as far as possible.
The primary and most simple way to reduce that risk is to never fully rely on one single investment. You should always consider diversifying your portfolio across several assets from different asset classes to reduce the probability of a severe loss during unexpected times.
No matter how confident you are about your next potential investment, it is crucial to your long term success to always assess the possible downside of each investment you make.
