The Investing Series: Rate of Return
Welcome to another Whiteboard Wednesday! This week we continue with our super-special series about investing. If you’re just now joining us (glad you could make it!), watch this video to get caught up!
Invest Like a Pro—The Book Is Optional
Today we are continuing our trek through the book I wrote, Invest Like a Pro. If you don’t want to read the book, no problem. We’ll cover the most important points in this series. If you prefer, you can pick up a copy on Amazon for 99 cents—they won’t let me price it any lower. It’s also free on Kindle Unlimited.
So far in this series, we’ve talked about how investing is for building wealth. Last week, we looked at how the amount of wealth we accumulate depends on both the size of our investment and how much time we have to wait for that investment to grow.
Today we’re looking at a third factor: rate of return.
How Fast Will Your Money Grow?
Rate of return refers to the speed at which your investment grows. Whenever you see a rate of return, always consider the fact that it can be affected by several variables.
Last week we used an example that assumed an 8 percent rate of return. What we didn’t account for in that example—for the sake of simplicity—was how the rate of return is affected by other variables like costs, taxes, inflation, etc. When you consider an investment, a really solid analysis has to account for the net, after-all-things, return. You get that by looking at all of the variables that affect your rate.
Let’s take a closer look at the variables:
The Value of the Underlying Asset Increases
This is a good thing. For example, if you buy your house for $200k and, in four years, it’s worth $220k, its value has gone up—that’s growth. The growth of your investment (a.k.a., your rate of return) has increased partly because someone else is willing to pay more for your house. Good news.
The bad news is, this is the only positive thing that affects your rate of return. Now let’s look at the reasons your returns could decrease …
If you have to pay taxes on the growth of your investment, that affects your rate of return. So, if your rate of return is 10 percent, but your marginal tax rate is 30 percent, you end up earning just 7 percent.
You know how, when you were little, your grandpa would say, “When I was a kid, for 25 cents, I could ride the bus both ways, get a candy bar, and go to a movie—you can’t do that now!” Yeah, so, inflation is a drag. Apply this to investing. If your investment returns 10 percent, but the value of the dollar decreased by 4 percent, your investment has only increased in value by 6 percent.
You want to avoid these as much as possible. Transaction fees come into play, a lot of times, with brokers. Mutual funds have transaction fees, too—they’ll sometimes be called “load fees”. If you trade stocks, the fee is applied to each transaction.
Investment fees are represented as an expense ratio. If you’re interested in investing in a mutual fund, you want the expense ratio to be as low as possible, all else equal.
If you’re paying your uncle to manage your investments, you should not. (Sorry, uncle.) Advisors charge what is called an “assets under management fee” and they fluctuate wildly from advisor to advisor. If you’re investing in a hedge fund, it can be pretty steep. If you’re investing with your uncle, maybe he’s cutting you a break and it’s only 50 basis points, which is 0.5%. One thing is certain: advisor fees reduce how much money you earn on your investment.
A small caveat: Advisor fees are most definitely a negative—and I used to take a really hardline approach to this—here’s the but: one reason that you might consider using an advisor, is because it removes emotion from your decision-making process. An advisor can help you step back and make sure that you’re taking a truly holistic view of your investments and financial picture. It’s a sanity check.
As we continue through this series, you’ll see that I don’t subscribe to the idea that you can pick an advisor that will somehow know which funds will beat the market, but we’ll get into all that later.
Many of us are in 401k, 403b or thrift savings plans. These plans are, essentially, a black box of fees. Most companies—and we’re proud to say that YNAB is an exception—don’t take the time to scrutinize retirement plan fees. They choose something off of the shelf. Unfortunately, there are many 401k providers that charge exorbitant fees that affect the growth of your investment. For example, if you expect to get a 12 percent return on your 401k, you might think that you only need to set aside $200/month to plan for a comfortable retirement. Just be sure that you understand exactly where that 12 percent is coming from.
Keep Your Eyes on the Prize
As you can see, after you account for taxes, inflation, and fees, your expected return on investment can change dramatically.
Don’t worry. As we move forward with this series, I’ll show you how to focus on the parts of investing that you can control (so you can ignore the rest). By following some simple guidelines, and basically doing less, you will do better than most.
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