As an investor, it's important to aim for a 5% annual return at a minimum.
Since there are very few completely safe fixed-income investments that pay anything close to 5%, you’ll need to spread your portfolio over several different asset classes to produce that kind of return.
In the process:
Be aware that higher returns come with higher risk.
Safer investments tend to offer lower returns while riskier investments offer higher potential returns.
Diversifying across several different investments helps to offset that risk, but it doesn’t guarantee a return of 5%, or any specific rate for that matter.
The most basic answer is that the whole purpose of investing is to grow your money.
You can do that by investing in CDs paying 2% APY, but with the average annual rate of inflation being just over 2% over the past 30 years the most you would do is keep up with inflation.
But you won’t be investing for growth.
An average annual return of 5% will enable you to both keep up with inflation and grow your money.
For example, if you hold $10,000 in totally safe investments paying 2% per year over the next 30 years, it will grow to $18,151.
But when inflation is factored in, it’ll still be worth no more than $10,000 in today’s money. But if you invest $10,000 in a blended portfolio averaging 5% per year over the next 30 years, it will grow to $43,219.
That will result in real growth in your initial investment of more than $25,000.
That’s what investing is all about.
The tricky part:
There’s no totally safe way to earn 5% consistently.
To get there, you’ll have to add some risk investments to your portfolio mix.
Risk level: High
The whole reason why stocks are such popular investments is because they have easily outperformed fixed income investments for more than a human lifetime.
Stocks have had an average annual rate of return of 10% going all the way back to 1926.
The caveat with stocks, of course, is that the 10% average is just that, an average.
There are many years when the market has been up 25%, and others where it’s been down 25%. But the key is the long-term average, and that’s what you’re banking on with stocks.
You can hold individual stocks, but that requires considerable investment knowledge. It can also be costly in terms of fees involved with buying and selling individual issues.
You would also need a very large portfolio to be able to adequately diversify.
Stock mutual funds and ETFs
For the vast majority of investors, the better choice is to invest through funds.
A mutual fund is a portfolio of stocks, typically actively managed in an attempt to outperform the general market.
But be aware that very few mutual funds outperform the market over the long-term. In addition, mutual funds come with fees known as “loads”, that can be as high as 3% of your investment principal.
ETFs work like mutual funds, in that each represents a portfolio of stocks (or other investments). But they are typically tied to an index of stocks, rather than a hand-selected portfolio.
This results in lower investment fees, and an absence of load fees.
With ETFs, you won’t outperform the market, but you won’t underperform it either. And just as important, ETFs can be bought and sold just like stocks, and don’t have minimum investment requirements.
Examples of popular ETFs include:
Risk level: High
Returns on residential real estate have averaged about 10.6% for the last 20 years according to Investopedia. But since there are so many variables with direct real estate investing, that number is at best a ballpark.
For example, real estate returns have been higher in large coastal cities than they have been in most of the rest of the nation.
As well, direct ownership of real estate can be labor-intensive.
You have to maintain the property, including making repairs when necessary, but you may also be involved in the rental process.
An easier, and potentially more profitable way to invest in real estate is through real estate investment trusts, more commonly known simply as REITs.
These are much like mutual funds, except they hold real estate instead of stocks. They typically invest in either commercial property or large residential complexes.
According to the MSCI US REIT Index, the average annual rate of return on REITs has been 16.1% over the past 10 years.
Peer-to-Peer (P2P) Loan Investing
Risk level: Medium
These are a relatively recent investment category, in which you invest in loans made to borrowers through an online platform.
They pay more than what you can get on bank investments. For example, the median return on an investment through Lending Club is 4.5%, but you can increase that return with higher risk investments.
P2P investments aren’t totally safe either.
But it is an opportunity to reach the 5% mark by investing in a balanced portfolio of notes.
Risk level: Low
Bonds can get you an annual return of 5% or better – or not!
Here’s the problem:
Bonds are supposed to be safe, but they’re not entirely.
They’re safe in the sense that they pay a fixed rate of interest, and your principal will be fully repaid upon the maturity of the bond.
But the safety complication of bonds is interest rate risk.
When interest rates fall, the market value of the bond can rise.
But when interest rates rise, the market value of a bond can fall.
A lot can happen over the lifespan of a 20- or 30-year bond. In certain years, bonds can yield higher than 5%. But in others, you could even lose money.
There are also different types of bonds. Perhaps most popular is the 30-year US treasury bond, currently yielding 2.75%. Since they’re issued by the US government, they’re considered super safe. But within the term of 30 years, their price can bounce around like stocks.
Your interest is guaranteed, but your principal value between now and maturity is not.
There are also high-grade US corporate bonds, which of late have been yielding 6.0%, but mainly because interest rates have been falling in recent months.
Then there are high-yield bonds currently yielding 8.3%, again because of the recent declining interest rates. They pay the highest rates, because they are not considered investment grade bonds, and therefore carry a much higher degree of risk of default.
Given the current very low level of interest rates, future returns on bonds are likely to be very unpredictable, and maybe even negative.
Risk level: Low
Annuities are a mixed bag.
The good news is that you can get a return of 5% with certain annuities.
The bad news is that they’re not particularly liquid, and if you do try to cancel early, you’ll be hit with potentially high surrender charges. And with some types of annuities, you can’t get your money back at all.
An annuity is a contract you make with an insurance company. You turn a certain amount of money over to the insurance company in exchange for a future cash flow.
You can either have an immediate or deferred annuity.
An immediate begins paying benefits immediately, while deferred begins paying at a later date.
There are all kinds of annuities available, but we’re going to focus on a fixed-indexed annuity (FIA).
It offers a combination of a fixed income with potential participation in a rising stock market.
Your initial investment is guaranteed, and you will usually receive a certain minimum return even when the stock market is falling. In exchange, your earnings in a rising market are capped.
It’s an investment contract that attempts to provide consistent returns within specified earnings limits. But as complicated as annuities are, they’re not for everyone, or even for most people.
Risk level: Low
Bank investments pay very low rates of return compared to other alternatives on this list.
But the primary attraction of bank investments is safety of principal. You should have at least some of your money in bank investments for complete protection.
Unfortunately, returns are not particularly good. For example, the interest paid through banks and credit unions are an average of just 0.9% on savings accounts, 0.18% on money markets, and 0.65% on 12-month CDs.
But you can earn higher returns by investing with online banks.
You can also look at some unconventional ways to earn money through a bank account.
For example, Consumers Credit Union is currently paying as high as 5.09% APY on account balances up to $10,000, when you have at least $1,000 per month in credit card transactions. However, the rate drops to 0.20% for balances over $10,000.
In an even more daring arrangement, with a Netspend Prepaid Card you can earn up to 5% APY on funds transferred from your prepaid card to an attach savings account. However, that interest rate will only be paid on balances up to $1,000. Higher account balances will pay just 0.50% APY.
There’s nothing you can do to earn a guaranteed and risk-free return of 5% or higher on your money.
But you can reach that target by spreading your money across several different investments.
For example, by investing half your portfolio in fixed income investments paying 2%, and the other half in stocks or a REIT averaging 10%, you’ll get a blended average return of 6% on your portfolio.
You’ll be adding some risk to your investments, in the form of stocks and real estate, but the greatest risk of all may be accepting safe but very low returns.
Inflation guarantees you’ll lose money on that arrangement.
So add some risk to your portfolio, and increase your returns to at least the 5% level. Your future self will be glad you did.