What Return Can You Expect on Your Investments?
Where you decide to invest your money can significantly affect how fast your funds grow and how much risk you are exposed to. In general, lower risk investments yield lower returns while higher risk investments have the potential for much higher returns but experience more volatility. A well-balanced portfolio will spread your money across different investments to lower risk and maximize gains. Funds that you will need in the short-term should be in relatively safe investments that offer liquidity while money you will not need for many years can be invested in more volatile investments that offer higher return potential. Potential investments to consider include cash & commodities, bonds & securities, stock market investments, and real estate.
Cash & Commodities
Bank products offer very low risk investment options including certificates of deposit (CDs), savings accounts, and money market accounts. When you purchase a CD, you agree to loan the bank a certain amount of money for a predetermined amount of time and interest. Savings accounts offer an annual percentage yield (APY) on your deposited funds. A money market account offers a higher APY than most savings accounts, typically with higher minimum deposit and balance requirements. Your funds deposited into a CD, savings, or money market account are insured by the FDIC up to at least $250,000. However, the downside is that interest rates currently offered on consumer deposit products by banks are low. Too low, in fact, to keep up with inflation. Interest rates are rarely offered above 1% for CDs and money market accounts. For savings accounts, the national average APY is a paltry 0.07%. Some brick-and-mortar banks offer as little as 0.01% on their savings accounts. While bank products are a safe place to stash your emergency fund for easy access, you will want to branch out to invest the rest of your money.
Commodities, such as silver, gold, or crude oil, are often seen as lower risk. By definition, commodities are basic goods that can be transformed into other goods and services. Investing in commodities is one of the more popular ways to hedge against inflation. Commodities tend to be more volatile than other investments. Political actions, environmental changes, and other external factors can suddenly and drastically influence the price of commodities. Many investors like that they can take possession of a physical product when investing in gold in the form of bullion bars or coins. However, just because gold is one of the oldest investment types does not mean it is without risk. Gold pricing is based on scarcity and fear. Prices tend to rise when scarcity and fear is more common and fall as fears reduce. Gold can be a good investment if you think the world will be a more fearful place in the future than at the time of purchase.
Cryptocurrencies are a newer type of investment in a unique type of digital asset. A cryptocurrency is a virtual currency secured by cryptography, which ensures that the cryptocurrency is nearly impossible to counterfeit or double-spend. Cryptocurrencies have the advantage of being easier to transport and divide than precious metals like gold and of existing outside the direct control of central banks and governments. Stories of overnight Bitcoin millionaires have piqued mass interest in cryptocurrency investment. While there is certainly significant return potential in cryptocurrency investment, there are some drawbacks. Cryptocurrencies are unregulated and come with particular risks: the possibility of future governmental regulation and the risk that a particular cryptocurrency will never gain sufficient acceptance as a form of payment. As cryptocurrencies have only been around for a decade or so, they have an unknown rate of return that makes it harder to make long term predictions. Due to their volatile nature, you may want to delay investing in cryptocurrency until after you have a well-established emergency fund and have built a balanced portfolio of other investments.
Bonds & Securities
Bonds and securities are low risk investments that come with a higher average return than bank products. Bonds are loans to the entity you purchased it from for a set amount of time and interest. Governments and corporations issue bonds to raise capital for projects and operations. Treasury securities, U.S. government bonds that are backed by the “full faith and credit” of the U.S. government, carry minimal risk and correspondingly low interest rates – often below the rate of inflation. Municipal bonds issued by state and city bonds are slightly riskier but offer more competitive interest rates. Current average rates for municipal bonds are somewhere between 2-2.25%. Corporate bonds carry a little more risk for the reward of a higher interest rate. According to Moody's Seasoned Aaa Corporate Bond Yield, the average rate of return was 2.60% as of Feb 09 2021. The long-term average is 6.66% but recent years have seen lower rates. Foreign governmental bonds are also available and carry varying amounts of risk and reward. Bonds are included in most investors’ portfolios to reduce risk. Retirees often include a higher portion of bonds in their portfolios to avoid sudden losses from market fluctuations.
The Stock Market & Investment Funds
When you purchase a stock, you are purchasing a sliver of that company’s earnings and assets. Stock investments allow for fractional ownership of many different companies. The stock market, as captured by the S&P 500, has yielded an average rate of return of about 10% over the last century. Investing in a single company’s stock exposes you to more risk if the company does poorly or goes under. Sears Holding Corp, the parent company of Kmart and Sears, hit their all-time high stock-closing price on April 17, 2007 at $193 a share. Today, shares trade well under $1. On the other hand, investing in Tesla shares at $17 during their IPO in 2010 would have made you a fortune – Tesla trades at over $800 a share today.
To minimize risk and diversify your stock investments, consider mutual funds, index funds, and exchange-traded funds (ETFs). Mutual funds allow you to purchase small shares of a large number of investments in a single transaction. Mutual funds are professionally managed and follow a set strategy to invest in stocks, bonds, or a mix of both. Mutual funds come with an annual fee, called an expense ratio. Index funds are mutual funds that passively track an index, such as the S&P 500, by holding stock of the companies within the target index. Expense ratios for index funds are lower than actively managed mutual funds. ETFs are a type of index fund distinguished by how they are purchased. ETFs are traded on an exchange like a stock, which means you can buy and sell ETFs throughout the day and the ETF’s price will fluctuate throughout the day. Mutual funds and index funds are priced once daily at the end of each trading day. Mutual funds, index funds, and exchange-traded funds may also pay out dividends and interest to investors, depending on the holdings of the fund.
Stock options are a way to limit your losses to the set price of the contract. When you purchase a stock option, you are given the right to buy or sell shares of that company at a predetermined price within a certain timeframe. Options offer flexibility – you can let the contract expire without exercising your right to buy or sell. Most options contracts are for 100 shares of a given stock. When you purchase a stock option, you are buying the contract with the right to buy or sell, not the stock itself. It’s typically used for a stock you expect to increase in value. If you are correct, you can purchase the stock for less than its current price and turn a profit. If you own stock in a company but are worried about losses, you can purchase an options contract that gives you the right to sell a specified number of shares at a set price, which you can exercise if the stock price falls. Options contracts can also be resold to other investors.
Many investors like real estate investing because it is relatively easy to understand. Investing in and managing real estate property comes with a high initial capital outlay in most cases. To make a profitable investment, you will want to find a property that you can purchase with a margin of safety. You can make a profit by buying a property below market rate and selling at full price or by renting or leasing the property to tenants. Managing real estate can come with unexpected expenses and requires a decent amount of time devoted to upkeep or a monetary cost to outsource those tasks.
Real Estate Investment Trusts (REITs) allow you to invest in real estate without having to personally buy, manage, or finance any properties. A REIT is similar to a mutual fund, gathering the funds of many investors and investing them in a collection of income-generating real estate properties. REITs can be bought and sold like stocks on the stock market. The barrier to entry is much lower – if you can purchase a share or fractional share of a REIT, you can become a real estate investor. EITs are required by law to distribute at least 90% of their taxable income to shareholders. Due to this, REITs tend to be among the companies paying the highest dividends.
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About the Author
Kaushal “Ken” Majmudar, CFA founded Ridgewood Investments in 2002 and serves as our Chief Investment Officer with primary focus on managing our Value Investing based strategies. Ken graduated with honors from the Harvard Law School in 1994 after being an honors graduate of Columbia University in 1991 with a bachelor’s degree in Computer Science. Prior to founding Ridgewood Investments in late 2002, Ken worked for seven years on Wall Street as an investment banker at Merrill Lynch and Lehman Brothers where he has extensive experience working on initial public offerings, mergers and acquisitions transactions and other corporate finance advisory work for Fortune 1000 companies. He is admitted to the bar in New York and New Jersey though retired from the practice of law.
Ken’s high level experience and work with clients has been recognized and cited on multiple occasions. He is a noted value investor who has written and spoken extensively on the subject of value investing and intelligent investing. He has been a member of the Value Investors Club – an online members-only group for skilled value investors founded by Joel Greenblatt, SumZero – an online community for professional investors, and has also written for SeekingAlpha – among others. Ken is active in leading professional groups for investment managers as a member of both the CFA Institute and the New York Society of Securities Analysts.