Investments with higher risks must yield better returns to justify their risks. That’s why savings accounts pay 1% or less in interest annually, while returns on other investments can be ten times that figure or more.

However, novice investors often make the mistake of chasing unrealistic rates of return without understanding the crucial relationship between risk and return.

Risk, Volatility, and their Measurement

Investment risk refers to the possibility of ending up with less money than you started with.

For instance, when you purchase a bond, you’re essentially lending money to the bond issuer. You expect a return on that loan, namely the interest paid by the bond. However, the company or government repaying the loan may fail to meet its obligations.

If you buy a $1,000 bond but the borrower only returns $750 before defaulting, you lose $250, not to mention the loss of the expected return.

Investors are willing to take risks because it’s the only way they can expect returns. They also demand compensation for the volatility of their investments.

When you buy shares of a company, you’re only paying its current value. The stock market operates five days a week, with people buying and selling stocks every second the market is open.

The value of the stock you bought may rise or fall within seconds of your purchase. A week or two later, its value may be half or double what you paid. Despite the overall market steadily rising over the past century, trying to predict short-term stock prices is nearly impossible.

The extent to which the value of an investment changes over a short period and the direction it might move in is what’s referred to as volatility in investing.

Investments with higher volatility need to provide higher returns to justify their volatility.

So what constitutes a good investment return?

Because investment returns depend on their risks and volatility, a good return on investment is one that exceeds the requirements of their risk and volatility. Comparing it to similar investments helps understand the return required to justify the risk and volatility of an investment.

If every savings account in the world offers 1% interest, and you find one offering 1.2%, that account offers the best investment return. This can be confidently stated because you’re getting an additional 0.2% return without taking on extra risk or volatility.

Seeking Alpha

In the investment realm, alpha and beta are used to measure investment returns considering risk.

Alpha (α) compares the return you get from an investment with its risk and volatility. Its formula is:

α = Actual Return – (Risk-free rate + (Market return – Risk-free rate) * beta)

The risk-free rate is the return achievable by investing in a risk-free investment. Typically, U.S. investors use the return on three-month Treasury bills as the risk-free rate.

Positive alpha means you’re getting returns higher than expected given your investment’s risk and volatility. Negative alpha indicates your returns are worse than what your risk warrants.

Calculating alpha requires knowing the beta of the investment.

Beta (β) is a measure of an investment’s volatility. It’s calculated using complex regression analysis. A beta value of 1 means the stock’s volatility matches that of the overall market. Higher beta values mean higher volatility, while lower ones mean lower volatility.

Average Returns for Different Asset Classes

Different asset classes such as stocks, bonds, precious metals, real estate, etc., carry different levels of risk. Certain parts of investments have become common knowledge due to the inherent risks associated with investment types.

Stock investments offer high returns but come with higher risks, while bond returns are slower but more stable.

So what constitutes good investment returns? The stock market’s best one-year return is 54.2%, with bonds at 32.6%, and real estate at 27.6%. However, these should be seen as the unsustainable upper limits of investment returns, defined by one-year historical highs.

1-Year Returns for Various Asset Classes Since 1926

As you can see, the higher the risk, the higher the average return on your investment. The listed returns are indices for these assets, meaning if you buy a tiny bit of every stock in the US or every available bond, that’s the return you’d get.

If you have more insight into investments, you can attempt to beat the market, although it’s challenging, even for professionals. Only one in ten professional mutual fund managers manages to outperform the market each year. Even for professionals, it’s hard to know what stocks to buy.

Achieving Higher Investment Returns

Real estate is an investment that can significantly boost returns. If you’re willing to improve homes yourself, you can flip houses for substantial profits or rent them out for much more than your monthly mortgage payments.

You can also buy properties in currently unremarkable or even depressed neighborhoods that are on the rise or likely to rise soon (though investing in less-than-pleasant neighborhoods is another example of taking on more risk for potentially higher returns… but also potentially more headaches). If your house is in an emerging neighborhood, kept in good condition, and the community improves with rising property values, you can sell it for a tidy profit.

How Fees Impact Your Returns

One thing to be mindful of when striving for the best returns possible is how fees affect your returns over time. Even if you manage to consistently beat the market by 1%, if your trading fees and expenses total 1.5% of your investment, you’re actually losing out.

High fees charged by asset management firms make it harder for them to earn substantial returns for you since they have to beat the market by a percentage higher than their fees each year.

Here’s an example to illustrate the impact of fees over time. If you invest $10,000 at a 10% rate of return for 30 years, you’d end up with $174,494.02. Add fees as low as 0.5%, and your balance drops to $152,203.13. That’s over $20,000 less.

Finding low-cost investment options is as crucial as finding investments that offer good returns. Choosing one of the best online stockbrokers is paramount.

Understanding risk and its relationship with returns can be challenging, but ensuring you only take on risks commensurate with the returns you expect can help you avoid costly mistakes in your investments.