What Is a Good Rate of Return?

What constitutes a “good” rate of return can be elusive and highly subjective, varying significantly from one investor to another based on their individual financial goals, risk tolerance, and investment horizon. However, the concept of rate of return is pivotal in understanding how investments grow over time and how different strategies yield different outcomes. This post examines how risk and reward shape returns, methods for calculating returns, and the importance of benchmarking to assess performance.

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How Diversification Influences Your Rate of Return

Modern Portfolio Theory shows that accepting higher risk can lead to higher rates of return. And, an optimal mix of investments balances your objectives with your risk tolerance.

Diversification is the only free lunch when it comes to investing. Diversification spreads your investments across various asset classes, sectors, or geographic regions to reduce risk. By not putting all your eggs in one basket, you can mitigate the impact of poor performance in any single investment. While diversification doesn’t guarantee a high rate of return, it can stabilize your returns over time by balancing out the highs and lows of individual investments. This strategy helps smooth out volatility and can lead to more consistent long-term growth. So, a good rate of return will depend on your objectives and the mix of investments you choose.

Calculating Rate of Return: TWR vs. IRR

There are a few different ways to calculate your rate of return. Including the Time-Weighted Return (TWR) and the Internal Rate of Return (IRR).

Time-Weighted Return (TWR) is a method of measuring the performance of an investment portfolio by eliminating the distorting effects of cash flows into and out of the portfolio. TWR is most often used to evaluate equity (stocks) portfolio returns.

The Internal Rate of Return (IRR) is a financial metric used to evaluate the profitability of potential investments. IRR is most often used in corporate finance, real estate, and fund investments.

TWR vs IRR: Which is Better For You?

The most popular rate of return measurement method depends on the context and purpose of the evaluation. For individual investors and financial advisors, the Time-Weighted Return (TWR) is often preferred. Because, it measures the performance of the investment itself, unaffected by the timing of cash inflows or outflows. This makes it ideal for assessing the performance of fund managers or investments. Where the investor does not control the timing of transactions.

On the other hand, the Internal Rate of Return (IRR) is more commonly used in corporate finance and real estate investment, where the focus is on the overall profitability of projects and the timing of cash flows is crucial to decision-making.

Benchmarking Your Rate of Return

To determine whether a rate of return is good or bad, investors must use benchmarks. This means after calculating a rate of return based on a TWR or IRR method. Then, investors should compare this rate of return against similar investments.

For example, investors could compare the TWR of a stock portfolio against an index of stocks such as the S&P 500. Or, compare the returns of a real estate project against the cost of financing, like a bank prime rate or borrowing rate.

Stocks for the Long Run

In the classic book entitled Stocks for the Long-Run, author Jeremy Siegel argues that stocks are generally the best investment. Bonds, Cash Deposits, and other fixed rate investments will perform poorly compared to stocks. There are many explanations for why this is true including the equity risk premium and the reality that gains made from innovation flow to the owners of capital.

Tax Tips to Maximize Your Rate of Return

When investors take a long-term buy-and-hold approach, they can increase their rate of return by reducing the taxes they pay. This is because each time an investment is sold to realize profits, capital gains taxes are owed.

The more often you’re trading, the more taxes you’ll likely be paying. Unless you’re a terrible investor and your trading is unprofitable. In which case, stop trading for that reason.

Contact us for more tips on how you can optimize your investments!

How to Achieve the Best Rate of Return

If your goal is to achieve the highest long-term results with a moderate risk. Then, the best strategy is to embrace a simple investing philosophy of buy-and-hold. This often means buying a high-quality portfolio of stocks, real estate, and private equity that you can hold for decades.

Investors should embrace simplicity. Not only will this provide greater economic results, but it will also provide greater peace of mind.

Try out our free investment policy generator to get personalized advice on how you should be allocating your investments!

How Our Family Office Supports Investors

Our family office supports wealthy investors by helping them organize and simply their financial lives. This means doing the administrative work like documenting statements, preparing bookkeeping, and creating financial reports so our clients can spend less time on details and more time on the things that matter most.

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