Portfolio Gains: Is 5% Enough?

Whether a 5% gain in an investment portfolio is reasonable depends on several factors, including the type of investment, the level of risk involved, and the time frame.

For example, a 5% return on investment may be considered reasonable for low-risk investments such as government bonds or savings accounts, but it may not be considered sufficient for higher-risk investments like stocks or real estate.

Additionally, the performance of the overall stock market, economic growth, corporate performance, interest rates, and share valuations can impact investment returns.

It's important to consider factors like diversification, time in the market, and individual financial goals when evaluating the reasonableness of a 5% gain in an investment portfolio.

Historical stock market returns

• 150 years: 9.352% (or 6.991% adjusted for inflation)
• 100 years: 10.628% (or 7.454% adjusted for inflation)
• 50 years: 11.866% (or 7.803% adjusted for inflation)
• 30 years: 10.733% (or 7.998% adjusted for inflation)
• 20 years: 10.473% (or 7.712% adjusted for inflation)
• 10 years: 12.864% (or 9.783% adjusted for inflation)
• 5 years: 14.873% (or 10.308% adjusted for inflation)

It is worth noting that these average returns do not account for the impact of volatility and inflation, as well as taxes, fees, and asset allocation, which can significantly affect the realised returns for investors. Therefore, a more realistic expected return for an aggressive investor (primarily invested in stocks) might be closer to 7%, and for a balanced investor (invested in a mix of stocks and bonds), 5% would be more appropriate.

Additionally, the timing of entry and exit from the market can significantly impact returns. For example, an investor who bought into the SPDR S&P 500 ETF Trust (SPY) between 2014 and 2018 would have experienced better returns than one who invested during the market highs of 2020-2023.

Unrealized gains

For example, if you buy a stock for $100 and its market value rises to $150, you have an unrealized gain of $50. This gain remains unrealized until you sell the stock and lock in the profit.

In terms of taxation, unrealized gains are generally not taxed because the profit has not been "realized" through a sale. Capital gains are typically only taxed when they are realized, and the tax rate depends on the type of asset, personal income tax rate, and how long the asset is held.

It's worth noting that there are some exceptions to the tax-exemption of unrealized gains, such as mark-to-market accounting rules and wealth taxes in certain countries.

Overall, unrealized gains are an important concept in investing, providing investors with an indication of potential profits, but they should be carefully monitored as they can fluctuate with market conditions.

Calculating ROI

The return on investment, or ROI, is a profitability ratio that measures the efficiency of an investment's performance over time. It is calculated by dividing the net income from an investment by the original cost of the investment, with the result being presented as a percentage.

ROI = (Ending value of investment – Initial value of investment) / Initial value of investment

For example, if you invest $10,000 in a stock at the beginning of a year and it grows to $11,000 by the end of the year, your ROI would be 10%.

It's important to note that a "good" ROI depends on various factors, such as individual financial goals and the type of investment. For instance, a young couple investing for their child's college education would have a different definition of a good ROI compared to a retiree seeking to supplement their income.

Additionally, the higher the risk of an investment, the higher the ROI investors typically expect. For instance, an average annual ROI of 8% would be considered good for government bonds but might not be viewed as favourable for small-cap stocks, which tend to be riskier.

ROI calculations can also be adjusted for risk to provide a more nuanced understanding of an investment's potential. This can be done using metrics such as the risk-adjusted return on capital (RAROC), which helps compare investments by adjusting returns based on the level of risk involved.

Furthermore, when calculating ROI, it is crucial to consider all relevant costs to ensure an accurate assessment. For instance, when calculating the ROI of a real estate investment, factors such as maintenance, repairs, insurance, and lost rental income should be included to avoid overstating the ROI.

Another important consideration is the holding period of an investment, which the basic ROI calculation does not account for. To address this, the annualized ROI calculation can be used, which takes into account the length of time an investment is held.

In summary, calculating ROI is a valuable tool for evaluating the efficiency and potential of an investment, but it should be used in conjunction with other metrics and considerations to make well-informed investment decisions.

Risk and volatility

Risk

Risk refers to the possibility of an asset losing value, or not meeting its expected value. This could be a monetary loss, or a situational loss, such as the difficulty of turning investments into cash quickly (liquidity risk). All investments carry some degree of risk, and generally, the higher the risk, the greater the chance for a high return.

There are many types of risk that investors should consider, including market risk, credit risk, liquidity risk, exchange-rate risk, commodity risk, country risk, business risk, operational risk, interest rate risk, and inflation risk.

Volatility

Volatility is a statistical measure of the dispersion of returns for a given security or market index. It is often associated with big price swings, either up or down. Volatile assets are considered riskier because the price is less predictable.

There are several ways to measure volatility, including beta coefficients, option pricing models, and standard deviations of returns. Beta is a popular way to compare the volatility of an asset to the market. A beta of 1.0 means an asset's volatility is equal to the market's. A beta below 1.0 means an asset is less volatile than the market, while a beta above 1.0 means it is more volatile.

Managing Risk and Volatility

To manage risk and volatility, investors can periodically review their portfolio, diversify their assets, and set obtainable goals. Financial advisors can also help individual investors to mitigate portfolio risk and market volatility.

While risk and volatility are not the same, they are closely related. A high-risk investment is often also highly volatile, as it can go up or down a lot. However, high volatility does not always imply high risk, especially when taking a long-term view. For example, stocks are often volatile in the short term, but over the long run, diversified stock investing is generally considered a relatively safe way to invest for long-term goals.

Additionally, volatility can create certain types of risk. For example, a retiree with a highly volatile portfolio might face liquidity risk if they are unable to sell assets during periods of high volatility when prices are down, as they would be locking in losses.

In summary, while risk and volatility are distinct concepts, they are intertwined in the world of investing. Understanding the differences between the two can help investors make more informed decisions about their portfolios.

Inflation

The impact of inflation on investments is twofold. Firstly, it reduces the purchasing power of an investment's returns. For example, if an investment yields a 2% return in a year when inflation is 2.5%, the investment has effectively lost value, as the purchasing power of the returns is less than the initial investment. Secondly, inflation increases the magnitude of investment losses. If an investment loses value, inflation compounds that loss over time, resulting in a larger overall loss.

To account for the effects of inflation, investors often calculate the inflation-adjusted return, also known as the real rate of return. This metric compares the nominal return of an investment (the advertised or initial return) to the inflation rate, providing a more accurate assessment of the investment's performance. For instance, if an investment yields a 12% return in a year when inflation is 3%, the inflation-adjusted return is approximately 9%.

When considering a 5% return on an investment portfolio, it is crucial to factor in inflation. While a 5% return may seem reasonable, if the inflation rate is higher than 5%, the investment is effectively losing value. Therefore, it is important for investors to seek investments that can maintain their value and generate returns that outpace inflation.

Certain investments are known to perform well during inflationary periods. Commodities, such as oil, gold, and other raw materials, tend to rise in value during inflation. Real estate, especially rental properties with periodic rent increases, can also be a good hedge against inflation. Additionally, specialized securities like inflation-indexed bonds, Treasury Inflation-Protected Securities (TIPS), and certain types of stocks and funds can offer protection against inflation.

In summary, when assessing the reasonableness of a 5% gain in an investment portfolio, it is essential to consider the impact of inflation. By understanding how inflation affects investment returns and exploring investments that are inflation-resistant, investors can make more informed decisions to protect and grow their portfolios.

Frequently asked questions