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 unique financial goals, and different strategies will have mixed results. We might hear from friends earning 5% a year or see folks on social media claiming to be able to turn $500 into $55k in a year! When marveling at the 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 benchmark their performance against a standard or index with comparable investments. 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.
Most professional investors avoid chasing super risky returns. Hedge funds rose in popularity because professionals found a way to manage or hedge away downside risk while also make 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&P500, a stock index that measures the performance of the top 500 companies in the US stock market. This benchmark is helpful for investors that will mostly be looking to buy 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&P500 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&P500 in January of 2009, we would have had $3.69 by the end of 2019.
The S&P500 return for the last 50 years (1969-2019) is about 6% per year after adjusting for inflation. This number is 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 you own 10-year bonds, an appropriate benchmark could be the 10 year US Treasury bond.
Here is an S&P500 return calculator that we can play with to see the returns over different time periods.
Many simple investments track the S&P500, so a yearly return between 6-12% after inflation can be reasonable for long-term stock investors.
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&P500 will be up 12% next year. By looking at long-term trends that include up and down years, we have guidelines of what to expect over time.
We should set our expectations according to our investments and set our investments according to our financial goals. Remember, different types of investments (for example, stocks vs. bonds) will have different benchmarks.
A standard or index with comparable investments that investors measure their performance against.