Stock Investing 101 – Required Rate of Return

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Required Rate of Return

This is the minimum rate of return needed from an investment before an investor would consider investing in it.

For example, if you have some money to invest but is currently servicing a mortage with an interest rate of 5%, your required rate of return from any investment you make will be 5%.

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What Is Rate of Return and What Is a Good Rate of Return?

Nov 13, 2020 5:34 PM EST

When you invest your money, the goal is to earn a good rate of return. But exactly what is a rate of return?

What Is Rate of Return?

As the name suggests, the rate of return is the percentage increase or decrease over your initial investment. It represents what you’ve earned or lost on that investment. The formula is:

Rate of Return = (New Value of Investment – Old Value of Investment) x 100% / Old Value of Investment

When you calculate your rate of return for any investment, whether it’s a CD, bond or preferred stock, you’re calculating the percent change from the start of your investment until the end of the period you’re measuring.

To do that, as shown in the formula above, let’s say you invested $1,000 in a company’s common stock two years ago, and now the value of your stock is $3,000. Subtract the old value from the new, which gives you $2,000, then divide that by the absolute value of $1,000 (the amount originally invested.) Multiply the answer by 100%.

Example of Rate of Return Formula

To illustrate this example:

1. Subtract current balance from original investment:

$3,000 – $1,000 = $2,000

2. Divide difference by the absolute value of original investment:

3. Multiply the quotient by 100% to turn it into a percentage:

2 x 100% = 200% Rate of Return

Interpreting Rate of Return Formula

If the old or starting value is lower, then you have a positive rate of return – a percent increase in value. If the starting value was higher, then you have a negative rate of return, or a percent decrease in value.

On the lower-risk end of the spectrum, savings and money market accounts can offer fixed rates of return. Fixed rate means that the rate will not change over time. The opposite of that is a variable rate, which is an interest rate that changes depending on how much interest rates rise or fall in the open market. Some Certificates of Deposit (CDs) offer fixed rates.

If you invest $1,000 in a one-year CD at a 2% interest rate, you already know what your rate of return will be – 2% – in exchange for letting the bank keep your money for a whole year. If you were to withdraw your money before the year was up, you’d be penalized for early withdrawal, and that would reduce your rate of return.

Assuming you keep the money invested in the CD in for the entire year, you’d calculate your gain at the end of it by taking the amount of your initial investment: $1,000 and multiplying it by the 2% rate of return in decimal form: .02.

How to Calculate Rates of Return for Different Investments

1. Bond Rates of Return

A bond’s return on investment or rate of return is also known as its yield. There are several different types of yield calculations. The most comprehensive is the total return because it factors in moves in the bond price, fees, compound interest and inflation.

To calculate a bond’s total rate of return, take the bond’s value at maturity or when you sold it. Add to that all coupon earnings and compound interest, and subtract taxes and fees. Then, subtract the amount of money you originally invested for the total gain or loss on the investment. Divide by the old value of the bond and multiply by 100%.

To simplify, if you bought a 4% coupon bond above par for 101, or $1,010, which pays $40.40 annually in interest, and then you sold it at par for $1,000 after having made $80.80 in interest, your rate of return would be about 7%.

(New Bond Value $1,000 + Coupon Interest $80.80 – Old Bond Value $1,010)/ ($1,010 Old Bond Value) x 100%

The bond’s rate of return is roughly 7%.

In a total return calculation, the compound interest, taxes and fees would have been factored in.

To find the “real return” – or the rate of return after inflation – just subtract the inflation rate from the rate of return. So if the inflation rate was 1% in a year with a 7% return, then the real rate of return is 6%, while the nominal rate of return is 7%.

2. Stock Rates of Return

When you buy stock, you’re buying a small piece of ownership in a company. Shares of stock have prices that rise and fall in a marketplace depending on factors like the company’s quarterly earnings and external conditions like interest rates and the economy. Some companies pay a quarterly dividend to share their earnings with shareholders.

To calculate the rate of return for a dividend-paying stock you bought 3 years ago at $100, you subtract it from the current $175 value of the stock and add in the $25 in dividends you’ve earned over the 3-year period. That gives you:

$175 new stock value – $100 old stock value = $75 gain

$75 gain + $25 dividends = $100 total per-share gains

$100 per-share gain / $100 per-share cost X 100% = 100% rate of return per share

Keep in mind that people usually purchase stocks through their brokerage accounts or vehicles like an Individual Retirement Account (IRA) or a 401(k) plan, which often charge fees that may alter the rate of return somewhat.

3. Real Estate Rates of Return

The rate of return for real estate purchases have a lot of costs to factor in, including interest rates paid on a mortgage loan. To get a rate of return on the sale of your home, take the sale price – say $580,000 after deducting closing costs, capital gains taxes and the cost of improvements you made to the home – and subtract the original purchase price you paid for home plus closing costs, about $500,000

(($580,000 – $500,000) / $500,000) x 100 percent = 16% Rate of Return

There is a plethora of other investment types, but you get the general idea for calculating a rate of return – new value minus old value, adjust for fees and income, divide by old value, multiply by 100%.

What’s Considered a Good Rate of Return?

Now that you know how to figure out the rates of return on the most common investment types, how do you know whether your investment’s return is good or not? What is a good rate of return?

Generally speaking, investors who are willing to take on more risk are usually rewarded with higher returns. Stocks are among the riskiest investments because there’s no guarantee a company will continue to be viable. Even huge corporations could fail from one day to the next and leave investors with nothing.

One way to minimize risk is to invest in a variety of companies in different sectors and asset classes (ie: stable value funds, bonds, real estate and stocks) over a long period of time. That may not lead to the 15%-35% returns you’re dreaming of, but diversification can spare you from a market crash wiping out your life savings. Investors who have remained invested in the S&P 500 index stocks have earned about 7% on average over time, adjusted for inflation.

The key to the S&P’s growth has been time – staying invested through low points until there’s an upturn. There have been long periods of growth when the index’s returns were heady, followed by bear markets with deep losses. The 90-year inflation-adjusted 7% rate of return is an average of some high peaks and deep troughs. Some stock market sell-offs have lasted for many years. For instance, the dot-com bubble burst in 2000 and by some measures has taken 17 years to recover.

Many stock investors are looking for the next Apple (AAPL) – Get Report or Amazon (AMZN) – Get Report in their zeal to beat the broad benchmark’s yearly average.

Saving for retirement is a daunting goal, and those who started a little late may chase yields that make them susceptible to fraud and Ponzi schemes. The rule of thumb for investing, as for most things – is that if it seems too good to be true, it probably is. If a fund or money manager guarantees 15%+ yearly returns, be skeptical. There is practically no way anyone can guarantee returns that high every year.

Among top five fund managers of all time, four were value investors who consistently beat the market and did so by ignoring hype and investing in undervalued stocks with strong fundamentals and low price-to-earnings ratios. If you want to beat the market during downturns, there’s a good chance you can do it by investing in a value fund or by being a value investor. Note, however, that value funds tend to under perform when the market is hot.

Bonds and Rate of Return

Bonds are known to be less risky than stocks, but there are certain classes of bonds that can be just as risky or riskier than equities. Luring investors with double-digit coupons, high-yield corporate borrowers with less than stellar credit hope to borrow some more and have to pay up to attract investors. Sometimes, the prospects of their ever being able to repay it are slim. Yields here can be high single digit to mid-double digit.

Countries like Argentina, Venezuela and Ecuador have offered sovereign debt with exorbitant yields because there’s a pretty good chance they won’t pay their debt either.

The U.S. credit crisis was caused by mortgage-backed securities, which are bonds backed by mortgages. They nearly collapsed our financial system. Bottom line is, don’t assume that because it’s a bond, it’s safe.

The safest bonds have traditionally been U.S. Treasurys. As inflation and interest rates have risen, so have Treasury yields. They’re considered safe because they’re backed by the full faith and credit of the U.S. government. Compared with other sovereign debt, U.S. Treasury yields are low – around 3% – because it is considered a haven.

Bonds are currently facing interest rate risk as the U.S. Federal Reserve has said it plans more interest rate hikes. Bond prices fall as rates rise because rates and bond prices have an inverse relationship. Long-term bonds have greater interest rate risk than those with similar creditworthiness and shorter maturities because with long bonds, there’s more time for rates to rise higher.

Investment-grade debt is somewhere in between Treasurys and high yield debt, and often offers the security of repayment guarantees, which stocks don’t have. Yields for investment grade bonds are about 100 basis points to 300 basis points below those of their high-yield counterparts. A basis point is a hundredth of one percent. Even the most rock-solid borrowers’ bond prices have been hit by rising interest rates, however, which is a risk that could last some time after the Fed’s nearly decade-long zero interest rate policy (ZIRP).

Which Portfolio Maximizes Returns?

A portfolio that’s 100% invested in stocks has historically had the highest returns compared with various other asset allocations of stocks and bonds, at about a 10% nominal return.

The only other asset that has matched stocks’ historically high returns as been residential real estate – including both housing prices and rental income.

Meanwhile, portfolio models that contained a larger share of stocks have historically outperformed those with heavier bond weightings, with all-bond portfolios showing the lowest average annual return at nearly half that of all-stock portfolios.

Typically, people who are closer to retirement age tend to be risk-averse and look for saver investments. Younger investors tend to take more risks because they have time to make up for big losses.

Target date mutual funds or ETFs take into consideration how long a person has before retirement and invests in a variety of securities that adjust over time to that investor’s needs. One complaint about these funds is that they may have higher fees given the greater variety of investments. They may not make the most of market moves, either.

As with any investment, it pays to stay informed and keep track of your holdings’ performance, keeping in mind that the most successful investors have stayed invested long term and avoided knee-jerk reactions to market moves.

How to Start Investing in Stocks: A Beginner’s Guide

Investing is a way to set aside money while you are busy with life and have that money work for you so that you can fully reap the rewards of your labor in the future. Investing is a means to a happier ending. Legendary investor Warren Buffett defines investing as “… the process of laying out money now to receive more money in the future.”   The goal of investing is to put your money to work in one or more types of investment vehicles in the hopes of growing your money over time.

Let’s say that you have $1,000 set aside, and you’re ready to enter the world of investing. Or maybe you only have $10 extra a week, and you’d like to get into investing. In this article, we’ll walk you through getting started as an investor and show you how to maximize your returns while minimizing your costs.

Key Takeaways

  • Investing is defined as the act of committing money or capital to an endeavor with the expectation of obtaining an additional income or profit.
  • Unlike consuming, investing earmarks money for the future, hoping that it will grow over time.
  • Investing, however, also comes with the risk for losses.
  • Investing in the stock market is the most common way for beginners to gain investment experience.

What Kind of Investor Are You?

Before you commit your money, you need to answer the question, what kind of investor am I? When opening a brokerage account, an online broker like Charles Schwab or Fidelity will ask you about your investment goals and how much risk you’re willing to take on.

Some investors want to take an active hand in managing their money’s growth, and some prefer to “set it and forget it.” More “traditional” online brokers, like the two mentioned above, allow you to invest in stocks, bonds, exchange traded funds (ETFs), index funds and mutual funds.

Online Brokers

Brokers are either full-service or discount. Full-service brokers, as the name implies, give the full range of traditional brokerage services, including financial advice for retirement, healthcare and everything related to money. They usually only deal with higher-net-worth clients, and they can charge substantial fees, including a percent of your transactions, a percent of your assets they manage, and sometimes a yearly membership fee. It’s common to see minimum account sizes of $25,000 and up at full-service brokerages. Still, traditional brokers justify their high fees by giving advice detailed to your needs.

Discount brokers used to be the exception, but now they’re the norm. Discount online brokers give you tools to select and place your own transactions, and many of them also offer a set-it-and-forget-it robo-advisory service too. As the space of financial services has progressed in the 21st century, online brokers have added more features including educational materials on their sites and mobile apps.

In addition, although there are a number of discount brokers with no (or very low) minimum deposit restrictions, you may be faced with other restrictions, and certain fees are charged to accounts that don’t have a minimum deposit. This is something an investor should take into account if he or she wants to invest in stocks.

Robo-advisors

After the 2008 Financial Crisis, a new breed of investment advisor was born: the robo-advisor. Jon Stein and Eli Broverman of Betterment are often credited as the first in the space.   Their mission was to use technology to lower costs for investors and streamline investment advice.

Since Betterment launched, other robo-first companies have been founded, and established online brokers like Charles Schwab have added robo-like advisory services. According to a report by Charles Schwab, 58% of Americans say they will use some sort of robo-advice by 2025.   If you want an algorithm to make investment decisions for you, including tax-loss harvesting and rebalancing, a robo-advisor may be for you. And as the success of index investing has shown, if your goal is long-term wealth building, you might do better with a robo-advisor.

Investing Through Your Employer

If you’re on a tight budget, try to invest just one percent of your salary into the retirement plan available to you at work. The truth is, you probably won’t even miss a contribution that small.

Work-based retirement plans deduct your contributions from your paycheck before taxes are calculated, which will make the contribution even less painful. Once you’re comfortable with a one percent contribution, maybe you can increase it as you get annual raises. You won’t likely miss the additional contributions. If you have a 401(k) retirement account at work, you may already be investing in your future with allocations to mutual funds and even your own company’s stock.

Minimums to Open an Account

Many financial institutions have minimum deposit requirements. In other words, they won’t accept your account application unless you deposit a certain amount of money. Some firms won’t even allow you to open an account with a sum as small as $1,000.

It pays to shop around some before deciding on where you want to open an account, and to check out our broker reviews. We list minimum deposits at the top of each review. Some firms do not require minimum deposits. Others may often lower costs, like trading fees and account management fees, if you have a balance above a certain threshold. Still, others may give a certain number of commission-free trades for opening an account.

Commissions and Fees

As economists like to say, there’s no free lunch. Though recently many brokers have been racing to lower or eliminate commissions on trades, and ETFs offer index investing to everyone who can trade with a bare-bones brokerage account, all brokers have to make money from their customers one way or another.

In most cases, your broker will charge a commission every time that you trade stock, either through buying or selling. Trading fees range from the low end of $2 per trade but can be as high as $10 for some discount brokers. Some brokers charge no trade commissions at all, but they make up for it in other ways. There are no charitable organizations running brokerage services.

Depending on how often you trade, these fees can add up and affect your profitability. Investing in stocks can be very costly if you hop into and out of positions frequently, especially with a small amount of money available to invest.

Remember, a trade is an order to purchase or sell shares in one company. If you want to purchase five different stocks at the same time, this is seen as five separate trades, and you will be charged for each one.

Now, imagine that you decide to buy the stocks of those five companies with your $1,000. To do this, you will incur $50 in trading costs—assuming the fee is $10—which is equivalent to 5% of your $1,000. If you were to fully invest the $1,000, your account would be reduced to $950 after trading costs. This represents a 5% loss before your investments even have a chance to earn.

Should you sell these five stocks, you would once again incur the costs of the trades, which would be another $50. To make the round trip (buying and selling) on these five stocks would cost you $100, or 10% of your initial deposit amount of $1,000. If your investments do not earn enough to cover this, you have lost money by just entering and exiting positions.

If you plan to trade frequently, check out our list of brokers for cost-conscious traders.

Mutual Fund Loads (Fees)

Besides the trading fee to purchase a mutual fund, there are other cost associated with this type of investment. Mutual funds are professionally managed pools of investor funds that invest in a focused manner, such as large-cap U.S. stocks.

There are many fees an investor will incur when investing in mutual funds. One of the most important fees to consider is the management expense ratio (MER), which is charged by the management team each year, based on the number of assets in the fund. The MER ranges from 0.05% to 0.7% annually and varies depending on the type of fund. But the higher the MER, the more it impacts the fund’s overall returns.

You may see a number of sales charges called loads when you buy mutual funds. Some are front-end loads, but you will also see no-load, and back-end load funds. Be sure you understand whether a fund you are considering carries a sales load prior to buying it. Check out your broker’s list of no-load funds, and no-transaction-fee funds if you want to avoid these extra charges.

In terms of the beginning investor, the mutual fund fees are actually an advantage relative to the commissions on stocks. The reason for this is that the fees are the same, regardless of the amount you invest. Therefore, as long as you meet the minimum requirement to open an account, you can invest as little as $50 or $100 per month in a mutual fund. The term for this is called dollar cost averaging (DCA), and it can be a great way to start investing.

Diversify and Reduce Risks

Diversification is considered to be the only free lunch in investing. In a nutshell, by investing in a range of assets, you reduce the risk of one investment’s performance severely hurting the return of your overall investment. You could think of it as financial jargon for “don’t put all of your eggs in one basket.”

In terms of diversification, the greatest amount of difficulty in doing this will come from investments in stocks. As mentioned earlier, the costs of investing in a large number of stocks could be detrimental to the portfolio. With a $1,000 deposit, it is nearly impossible to have a well-diversified portfolio, so be aware that you may need to invest in one or two companies (at the most) to begin with. This will increase your risk.

This is where the major benefit of mutual funds or exchange-traded funds (ETFs) come into focus. Both types of securities tend to have a large number of stocks and other investments within the fund, which makes them more diversified than a single stock.

The Bottom Line

It is possible to invest if you are just starting out with a small amount of money. It’s more complicated than just selecting the right investment (a feat that is difficult enough in itself) and you have to be aware of the restrictions that you face as a new investor.

You’ll have to do your homework to find the minimum deposit requirements and then compare the commissions to other brokers. Chances are, you won’t be able to cost-effectively buy individual stocks and still be diversified with a small amount of money. You will also need to make a choice on which broker you would like to open an account with.

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