To ensure you meet your financial goals, your investment plan must incorporate a reasonable rate of return for your investments over the long term. Consider the following when setting a long-term rate of return for your investments:
Review historical rates of return.
No one can predict future returns for any investment. Even though past returns are not a guarantee of future returns, the best that can be accomplished is to make an educated opinion based on past history. Past history reinforces the concept that investments with greater risk tend to have higher returns. For example, over the long term, short-term bonds tend to have lower returns than long-term bonds, which tend to have lower returns than stocks. Historically, investors have been rewarded for taking on more risk with higher returns.
Understand how risk can affect your return. All investments are subject to different types of risk, which can affect an investment’s return:
- Cash is primarily subject to purchasing-power risk, or the risk that its purchasing power will decrease due to inflation.
- Bonds are subject to interest-rate risk, or the risk that interest rates will rise and cause the bond’s value to decrease, and default risk, or the risk that the issuer will not repay the bond.
- Stocks are primarily subject to nonmarket risk, or the risk that events specific to a company or its industry will adversely affect a stock’s price, and market risk, or the risk that a particular stock will be affected by overall stock market movements.
At any point in time, one or more of these risks may be more predominant, affecting your rate of return.
Develop strategies to reduce risk. One strategy is diversification, which involves investing in more than one investment category, such as cash, bonds, and stocks, as well as within investment categories, such as owning several stocks in several industries. By owning several investments rather than just one, a downturn in any one will not have a significant impact on your total return. Of course, the reverse is also true — if you have one investment that is performing exceptionally well, your return will be lower than if that was your only investment.
A diversified portfolio should contain a mix of asset types whose values have historically moved in different directions or in the same direction with different magnitudes. Another strategy is time diversification — staying in the market through different market cycles. Remaining in the market over the long term reduces the risk of receiving a lower return than you expected. Time diversification is especially important for volatile investments, such as stocks, where prices can fluctuate tremendously over the short term.
While no one can predict future returns, understanding how risk affects return and developing strategies to reduce risk can help you set a reasonable expected rate of return for your investment portfolio. If your expected rate of return is reasonable, you will stand a better chance of attaining that rate of return and thus achieving your financial goals.