Become a better investor
Lesson in Course: Investing basics (beginner, 4min )
Creating goals and using strategies are important for success. How do we know if our strategy is working and how do we set reasonable expectations?
We all have individualized financial goals, and different strategies will have mixed results. We might hear that our friends earn 5% a year or see other folks on social media claiming to be able to turn $500 into $55,000 in a year! When marveling at amazing success stories, we need to keep in mind that most professionals don't beat the market.
These stories stand out because the magnitude of this success is incredibly risky and very difficult (or impossible) to reproduce. For every wild success story, there are many tragedies of people losing their entire portfolio, risking it all chasing a big payout.
So how do we set reasonable expectations for our investment returns, and how do we measure success?
Investors compare their performance against a benchmark.
The benchmark differs depending on the investments, the desired strategy, and the preferred outcome. Risky strategies might benchmark themselves to a basket of stocks, while more conservative strategies compare to a mixed basket of stocks and bonds. We need to make sure we're comparing apples to apples.
Most professional investors avoid chasing super risky returns. Hedge funds rose in popularity because professionals found a way to manage downside risk while also making money when the general market goes up. A year of significant gains followed by a year of losses is often less favorable than the steady compounding of modest gains over time.
Venture capital is often called risk capital. This style of investing is very risk-prone and subject to what is called power law. These investors make all of their money from a few very successful investments, while the rest are losses.
There have been some hedge funds that engage in risky bets. Steve Eisman of FrontPoint and Michael Burry of Scion Capital are known for betting against the housing market and big banks leading up to the subprime mortgage crisis of 2008. The movie "The Big Short" was inspired by this story.
One of the most commonly used benchmarks is the S&P 500, a stock index that measures the performance of the top 500 companies in the US stock market. This benchmark is helpful for investors looking to buy most stocks, mutual funds, and ETFs.
When measuring how we're doing, we need to consider the time horizon that we're comparing. Longer periods of time are more meaningful than short-term or day-to-day changes.
The S&P 500 over the 10 years from 2009 -2019 had an annual return of 12.6% after adjusting for inflation. If we had the chance of investing $1 in the S&P 500 in January of 2009, we would have had $3.69 by the end of 2019.
The S&P 500 return for the last 50 years (1969-2019) is about 6% per year after adjusting for inflation. This number is more meaningful because we include more changes in the market over a longer period: the major recessions in the 1970s, 1980s, 1990s, 2000, and 2008. For every $1 invested at the start of 1969 and held through the recessions, we would have $19.49 at the end of 2019.
The Dow Jones Industrial Average (DJIA) is another popular benchmark investors use to compare their stock portfolio performance. In the past, the DJIA has been an important indicator of economic health for the United States; however, it's fallen out of favor since it only includes 30 companies that may not fully represent the modern economy.
Bond portfolios are benchmarked against government bonds and specific bond indices. Government bonds, also known as Treasuries, provide a stable base to compare for all bond investors. For example, if we own 10-year bonds, an appropriate benchmark could be the 10 year US Treasury bond.
There's a typical disclaimer in the financial world, "past returns are not representative of future returns." This means there's no guarantee the S&P 500 will be up 12% next year. By looking at long-term trends that include both up and down years, you'll have a general sense of what to expect over time.
Many simple investments track the S&P 500, so a yearly return between 6-12% after inflation can be reasonable if you invest in stocks long-term.
A combination of factors, including your investment goals and risk tolerance, should determine the types of investments appropriate for you. This means you should set your expectations for returns based on those investments. Remember, different types of investments (for example, stocks vs. bonds) will have different benchmarks.