What is a "Good" Investment Return?

Part 1: It’s All Relative

A friend emailed me a while ago with some questions about her retirement plan. She confessed to not looking at her account at all in the last year (whoops!), and said the only reason she logged in was to download the tax forms she needed to file her 2016 return. In theory, this isn't so bad; you shouldn't obsess over short-term fluctuations in your retirement fund, so only looking at it once a year may prevent excessive and inefficient money "monkeying".

She then went on to say that her account returned 8.6% last year, which “seems low”, then asked “Is it?” And finally, ended her email with “HELP ME, I KNOW NOTHING!”

Help me, I know nothing!
— Smart Millennial Woman

My brain started whirring as it usually does when talking about investing. Her questions are not uncommon; the topic of returns may seem simple, but can actually be quite complex. Returns are one of the most powerful, yet easily misunderstood aspects of investing. What does that mean for you? The sooner you understand returns, the sooner you'll be able to harness their power. 

So, to properly discuss this subject, I've decided to trickle my response to her questions over a four-part series called “What Is A “Good” Investment Return?”.

Part 1: It’s All Relative

After reading her email, a few follow-up questions immediately popped into my head:

  1. How did the market do last year in comparison?
  2. What’s her risk tolerance / how is she allocated?
  3. What has her account returned per year on average since she started investing for retirement?
  4. What return was she targeting?

How did the market do last year in comparison?

This is important for a couple of reasons. First, returns are relative, which means they can only truly be evaluated in the context of other returns. Knowing how the market (mainly the S&P 500) did last year gives me a benchmark against which to compare her account’s performance.

Depending on who’s calculating, the S&P gained roughly 12% in 2016. Her 8.6% return is obviously a bit lower, but that's not necessarily a bad thing. In her case, the difference is driven by an important strategy called diversification, which leads me to my next point...

How is she allocated? What is her risk tolerance?

I could tell by the return alone that she has chosen to divide her account balance between mostly stocks and some bonds. (If she had allocated 100% to stocks, her account should have earned closer to 11-12% like the S&P 500 did. Don't worry, I'll explain more in Part 3 of this series). She confirmed for me that her entire balance is invested in a Target Date Fund which is split roughly 90/10 between stocks and bonds.

As for her risk tolerance, this particular friend is my age, so she's in the early stages of her retirement savings journey. Without having her take a risk survey, I would guess that she falls in the moderate to moderate-conservative area of the risk tolerance spectrum. These two factors (age and tolerance) tell me that she should probably employ a moderate to moderate-aggressive allocation strategy. She understands that investment success requires some risk, plus she's young enough that she can afford (time-wise) a little more volatility in exchange for larger returns.

What has her account returned per year on average?

While the stock market’s short term performance gets a lot of media attention, what really matters when it comes to your retirement savings is how your account performs over the long haul. That's because you have what's considered a long investing horizon when you're working and saving up for retirement.

Assuming the average person will stop working or slowly phase out of working in their mid-to-high 60s, each person has 40 to 50 years to accumulate their nest egg. And it's your portfolio’s average earnings over those 40 to 50 years that matters, not each year’s individual return. Yes, every year counts because it contributes to the average, but over the course of 40 years, each year’s effect gets "smoothed out". And it's the smoothed out number that gets factored into your target retirement savings calculation.

What return was she targeting?

That’s right! You should be targeting an average annual return in your retirement account! Unfortunately a lot of people don't have an actual numerical goal that they're working toward, nor do they understand two big factors that will determine their success: contributions and returns. Rather, they deposit random amounts of income into their accounts hoping it’s enough, then choose investments that don't usually match their risk tolerance or capacity.

In theory, the more you can afford to contribute, the lower the return you require to achieve your nest egg goal. Conversely, the less you can afford to save, the more you have to rely on higher returns to carry your retirement fund growth. That's why it’s important from a financial planning perspective to have targets for both factors. If you're falling behind on your retirement goal, you’ll have to adjust one of them: either increase/decrease your contribution, or increase/decrease your expected return.

That might sound complicated, but I promise you that it’s not. With a couple of simple calculations, you can figure out how much you should be saving and/or how much your savings need to earn to reach your goals.

I’ll cover the basic steps on how to do this in Part 4 of this series. I'm also working on a downloadable spreadsheet that you can use to plan your personal retirement savings strategy. In the meantime, my Bonus Reverse Retirement Calculator Tutorial is a great place to start.

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The ultimate test of an investment’s return is whether or not it helps you reach your financial goal.
— Tara Falcone, CFP®

At the end of the day, the ultimate test of an investment’s return is whether or not it helps you reach your financial goal. That's where having specific, measurable objectives and a solid plan to achieve them comes into play.

Start by writing down how much money you think you'll need to live off of every year in retirement. Get specific! Write down precise numbers for housing, groceries, insurance, etc. This will serve as the starting point for your calculations and get you ready to take full advantage of the handy-dandy spreadsheet I’m creating.

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Tara Falcone, CFP® , Founder of ReisUP | Facebook: ReisUP | Twitter: @reisupllc | Instagram: @reisupllc