When people start out on their investing journeys, the first question they typically have is what’s a good investment return and what can I expect from this? Is 5% a year good? 10%? It’s a good question. It’s a question that you should ask whenever presented with a myriad of investment options out there. There is a simple and more complicated answer.
The simple answer is anything above 8-10% per year can be considered good.
Obviously, there is more behind that number. It will significantly depend on your risk tolerance and goals. So the answer depends on what you invest in, but we must set realistic expectations for our peace of mind.
Intro to Benchmarks
Ah, the benchmarks. Nightmare of all professional investment managers. You see, their goal is to beat their respective benchmarks, and oh, so many of them cannot do that.
Mr. Warren Buffet, arguably the most successful investor of our time, challenged hedge fund owners to beat S&P 500 Index over ten years. Guess how it went. You got it; they lost badly! On average, returning only 22%, while the index returned over 85%. https://www.cnbc.com/2017/08/09/buffett-challenge-hedge-funds-vs-index-funds-9-years-on.html
That is why beating the “market” is the ultimate goal for many professional investment managers. And the “market” in many cases means S&P 500 Index. There are other benchmarks of course, but S&P500 is the usual go-to benchmark.
S&P 500 as a “good investment return” benchmark
What exactly is the S&P 500 and why is it the most popular benchmark? S&P 500 is the stock market index (in other words a collection of stocks) that measures the performance of the 500 largest companies listed publicly in the U.S. You can see how this makes it THE benchmark to beat and can be used as an indicator for what “good investment return is.
The index came about in 1926 with the merger of Standards Statistics Company and Poor’s Publishing company. Standards Statistics was a rating agency that gave out credit ratings on mortgage bonds, and Poor’s Publishing published investor guides.
S&P as an investment
Benchmark existing on its own is meaningless unless it represents an investment vehicle that we, regular folks, can actually invest in.
Thankfully there are ways to buy S&P500 easily through Exchange Traded Funds (ETFS). Without diving deep into ETFs, they are funds that you can invest in by buying them on the stock exchange. It is just like buying an individual stock, but you are getting a piece of the whole managed fund. There are funds that replicate the performance of the S&P 500. When we invest in these funds, it is essentially like buying the whole S&P 500 itself.
The most popular S&P 500 ETFS are tickers: VOO,IVV, and SPY.
SPDR’s S&P500 Trust ETF SPY is the world’s oldest Exchange Traded Fund, founded in January 1993. That is great because we can analyze its historical performance going back to 1993.
Investing in SPY gives us an annual return of 10.44%.This return will fluctuate depending on what historical period you select, but generally speaking, it is around the 8-10% range.
The best year for SPY was 1995, with a return of 38.05%.
The worst year for SPY was 2008, with a return of -36.81%.
As we can see, time of entry and period selection is crucial when calculating historical returns. If you bought SPY in 2007 expecting 10% growth but got a whopping 37% downswing, you would question this whole investing in the stock market thing.
It is vital to understand CAGR, expectations, and what the industry calls risk, or in other words, price volatility.
What is CAGR?
Compound Annual Growth Rate is the return rate required for your investment to grow from beginning balance to ending balance, assuming that proceeds are reinvested in the same investment vehicle at the end of every year. To see how CAGR works in more detail, take a look at our CAGR Calculator.
Inflation, management fees, and volatility
We must never forget about inflation. Everyday money loses some of its value. In North America, it is generally around 2-3% per year. That means holding cash costs you 2-3% a year. Also, this means, 10.44% is not quite accurate. The inflation-adjusted CAGR for SPY is 7.56% for the same period.
When you buy an ETF like SPY, there are people behind the fund that do the work of replicating the S&P 500. That work costs money. These funds charge a fee to pay for it, converted into a percentage of their assets, called an Expense Ratio. The ratio is calculated every year and directly reduces your return.
SPY’s expense ratio is 0.09%.
IVV and VOO have an expense ratio of 0.03%.
In a year when S&P 500 returns 10%, you should expect a return after inflation (assuming 2%) and expenses of 10% – 2% – 0.09% = 7.91%
Volatility measures price fluctuations of the asset, in this case, SPY, over a given period.
For the period we are looking at here, the Standard Deviation for SPY is around 15%. Many portfolios offer much lower volatility. Check them out here.
Why not just buy SPY and go home?
Okay, so we can expect around 8% return over a long enough period by investing in SPY or its equivalents. So why not just do that?
For many, it might be a good idea. It is simple, and it gives you a nicely diversified portfolio that you don’t have to manage. Just register a brokerage account and buy one ETF. But that might not align with everyone’s investment goals.
Not great for income
At the time of writing, SPY earns investors 1.27% from dividends (income paid to investors for holding stocks). 1.27% is relatively low for dividend investors. There are much better options for income-seeking investors.
Not great for risk-averse investors
For investors close to retirement that want to preserve their capital, this might not be the best portfolio for them. It does not generate much income, and two, there are safer portfolios out there that provide more stability.
Not great for enterprising investors that want to do better
You might look at SPY’s returns of 8-10% and say to yourself, can I do any better than that? And the answer is yes. It might not be easy and definitely not guaranteed but there are ways to invest in the stock market to generate better returns than that.
You must understand that stock market is a market where individual companies sell pieces of themselves. That means that there will be companies that will do much better than the overall average and some that will do much worse. Nobody is facing us to buy the whole market, we can be as selective as we want to be. That means if you can identify companies that are bound to do better than the market over a long period of time and you can do that consistently, then you will “beat” the market.
Read related: Can individual investors beat the market?
Benchmarks aren’t perfect
Benchmarks are a great way to measure your portfolio’s performance against something you could have bought instead. But always keep in mind that said benchmark might not align with your individual goals, so using a general S&P 500 as a standard might not be the best idea. We discuss that in more depth here: Do dividend stocks beat the market?