Dispelling the Myth of ROI
I was presenting to a small group of affluent investors about an investment I was considering. This was some years ago...
I showed the projections — conservative projections that had investors making 25 to 35% over two to three years, with some fringe benefits.
A large, bald-headed man in the back stood up and interrupted me.
He told the audience they would be wasting their money by investing in my idea.
“Unless you can give us a 10-to-1 return, I’m not interested in what you have to say,” he announced.
A few people applauded him.
The coveted “10-bagger.” What investor hasn’t dreamed of that?
The thing is, none of the successful stock investors I know advocate or follow this strategy.
I hear it touted by two groups of people: fund managers (like Peter Lynch), who are in the business of buying and selling stocks, and inexperienced, gullible investors like this man who interrupted me.
The fact is, chasing after extraordinary returns is the surest way to ensure you will never, ever become wealthy.
I’m not saying 10-to-1 returns don’t happen. I’m saying that they are extremely rare and highly unpredictable. Basing your wealth-building plans on beating the odds by such a wide margin is simply dumb. It ain’t gonna happen.
I know the rationale. You just need 1 win out of 10 to make it all worthwhile. I came up with that rationale 30 years ago when I was selling penny-stock newsletters.
It sounded sensible at the time. But I soon found out, after watching the actual results of our penny stock gurus, that what mostly happened was that investors lost all or most of their money.
Like my bald-headed critic, you may think that 8 to 15% returns are boring. If you do, I can only say this: You are wrong. You are foolish. And this idea will eventually make you poorer than you are today.
Return on investment, or ROI, is a performance measure used to evaluate the efficiency of an investment. To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment. The result is expressed as a percentage or ratio. In the case of our example, $3,800 divided by $20,000 = 0.19 or 19%.
Consider these facts about stock returns: According to Dalbar, the average investor earns 3.66% long term. An index of hedge funds shows that those have returned 3.4% in the last 10 years. And the SEC reports that penny stock investors typically lose an annualized -60.3%.
Compare all that with the S&P 500, which has earned about 10% on average per year for the last 30 years. Invest in a no-load index fund and you’ll already be better off than a majority of stock investors.
This brings me to a major point: If you have any serious desire to build substantial wealth through investing, you must understand the long-term average returns of every type of investing you do and expect to get no more than that over time.
What I’m telling you now is very important. It is also something I’ve never heard another financial writer say. A critical component of building wealth safely and steadily over the years is to accept the reality of every type of investment you make and don’t try to double or triple (or multiply by 10) that investment’s natural, long-term average return.
Another way of putting it is this: Every asset has its own intrinsic rate of return, based on historical averages that you can reasonably expect to earn. If you can figure out a way to get rich while getting those returns, then you have a sure-fire formula for accumulating true wealth.
What are those natural ranges of returns?
For a hundred years, stocks have been yielding 8 to 11% on average, depending on how you measure them.
Tax-free municipal bonds have given 4 to 5% over the years, which equates to 6 to 10% depending on your tax bracket.
If you like options, there is only one strategy I recommend. It’s the safest of all option strategies. And although it can give you up to 18% on specific trades on an annualized basis, if you do it conservatively as I recommend, you can count on making 8 to 12% on your money. (For more information about this strategy, click here.)
If you want returns that are higher than these, you must turn to investments that require a bit more attention on your part, such as tax liens, private debt, or income-producing real estate.
And if you want those huge returns — not just 10-, but 100-baggers — then you will have to take a very active role in your investments. You will have to invest in startup, entrepreneurial businesses.
There is a pattern here you may have noticed: If you want higher returns, you have to be willing to become more actively involved in the business. You have to learn how it works from the inside out. You have to put your energy and intelligence into improving it. And you sometimes will have to control it.
This is another thing most investment “professionals” will never tell you. They make their money by charging you commissions and fees on the stocks and bonds and other passive investments they sell you. That means they don’t want you to face the fact that if you try to beat these markets, you will almost surely become poorer.
They’d rather pump you up or say nothing and let the financial press get you hyped on their investment instruments.
In fact, they tend to scoff at real estate and entrepreneurial ventures as if they are somehow reckless or in some way inferior. I don’t know how they get away with implying that, but they do.
The truth is, if you want higher returns on your passive investing (stocks and bonds), you have to take higher risks, like they tell you. But what they don’t say is that when you take higher risks, they make more money, and you usually end up in the poor house.
The smart way to get high yields, as I said above, is to put more work into assets that offer proven high intrinsic rates of return.
Know this: 8 to 12% is a high rate of return. If you get an 8% return, you’ll double your money every nine years. If you get a 12% return, you’ll do it in six years. You can get very rich by doubling your money every six years.
Think of it this way... Warren Buffett — the most successful investor of all time and the third-richest person on the planet — has averaged 19% per year on his investments over his entire career. Expecting to make returns that are five times what the world’s greatest investor has made is just plain foolish.
If that doesn’t convince you, maybe this will: Back in 2007, Warren Buffett made a famous bet. He said that an unmanaged, low-cost S&P 500 stock index fund would outperform an actively-managed group of high-cost hedge funds in the next ten-years. (It did.)
Had Buffett made this bet in 2010, he’d have easily won. Again. In fact, in each of the last ten years (ending at the start of 2021), the average annual return on the S&P 500 was 14.4% or almost three times higher than the 5.0% average return for hedge funds.
