So, what's the realistic expectation ?
First, let's look at normal stock on the market, i.e. stocks you can trade daily on your online broker account, such as Etrade. For this, let's first understand the Modern Portfolio Theory, for which people actually win Nobel proce for it. The basic concept is that the financial market as a whole is most efficient. That is, one can not consistently achieve better return of investment than the average return of investment of the overall market. In another word, you can simply buy SPY and /or QQQQ, and that's the most efficient investment over long term. (more on the correctness and application of this on Sec 4.2 and Sec 4.3).
Now, what kind of return of investment you should expect ? In the boom days, people think 15% per year should be the expected annual return. However, if you look at how the 15% is calculated, the starting point is usually at the bottom of the market. If fact, there are 30 days in the past 10 years, and if you miss those 30 days, your return of investment will drop to at least 10%.
It is unrealistic to hope that you can correctly call the bottom (if so, you will be super rich). So, a more realistic return of investment of 7% per year. In fact, if you can do that, you are doing bettern than 50% of the mutual fund managers on Wall Street (which tells you that people on Wall Street actually do not know how to invest money. They are just better at charging you money.). Remember the7-10 rule we discussed earlier. 7% is actually a very good return. If you have $1,000 invested when you are in your 20s. By 60 years old, your money will be $1,000 x 2 x 2 x 2 x 2 = $16,000. (and the most important investment strategy : time is your most important friend.).
Given the slow growth of US economy right now, people starts to think 5% annual return is what should be expected for forseeable future (i.e. next 20 years). In any case, you should shoot for 5-7% annual return.
Why this is important ? It is in three fronts:
- when you examine your stock investment results, you should expect 5-7% return, and you should adjust your investment strategy according;
- when you decide when to sell a stock, you need to remember that you are looking for 5-7% average annual return for your investment. So, if any stock hits 10 - 15% return, you need to serious consider selling it. If it hits 15 - 20% return, you should definitely sell it. Do not be greedy. Otherwise, you are taking too much risk, or you are letting your emotion drives you;
- when you evaluate people who invest money for you, for example, your 401K or any mutual fund, you should make sure that they are at least making 7% return. Otherwise, why pay them if you can do better by yourself. The most interesting conversation I usually have with the financial advisers who are trying to pitch me something is like this :
-- Me : what kind of annual return I'm expecting ?
-- Financial adviser : this mutual fund (or, annuity, etc etc) has historical performance of 15%.
-- Me : how much you charge to manage the money for me ?
-- Financial adviser : we charge only 2% of your profolio and 20% of the gain.
-- Me : I do not trust that you can make 15% return per year.
-- Financial adviser : Believe me. Our history already demonstarted it.
-- Me : If you are so confident, let me propose this. If you beat the average market return which is 7%, I'll share 50% of any gain beyond 7% with you. If you are below 7% for any given year, you make up to 7% for me from your own pocket. And there is zero fixed fee. This is win-win for both of us since you are so confident about your results.
-- Financial adviser : we can not do that. We will lose money.
-- Me : so you actually do not believe that you can make 15%.
-- Financial adviser : (speechless)
I had fun every time in such conversation.
If you gets stock options or ESPP from your company (we will talk about this in Sec 4.5), you should expect 15 - 20% return. For example, for ESPP, you can get your company's stock at (normally) at least 15% discount. So, if you are selling at the day you get it (assume you are in the qualified selling period), you can make 15% with zero effort.
If you gets IPO stock (we will talk about this in Sec 4.4), you should expect 15 - 20% return as well. You are taking more risk in investing in IPO stock, so you should expect higher return. Follow our stratgey on IPO investment on Sec 4.4, and you should do just fine.
Now you have established your target, let's see how we can achieve it.
