- Achieving 10% per years is pretty simple, just follow three rules.
- Many forget to include risk in the 10% expected return puzzle.
- However, if you do your homework, yearly dividend yields of above 60% shouldn’t be excluded. An example will be provided.
I always talk about how the S&P 500 is overvalued and how everybody should achieve returns of more than 10% per year.
In fact, I strongly believe that anyone is easily capable of achieving such returns. To achieve returns, say, in the higher teens, you’d need to be a very good investor or have someone telling you what stocks to buy and when. But that puts us in the Buffett, Soros, Klarman, and Dalio category, so we’ll stick with the easy today and discuss how to achieve returns of above 10% per year.
Now, you might be thinking: but Sven, with interest rates on deposits close to zero, long term bond yields at 3% or at 0% in Europe, junk bonds with 5%, and stocks with an earnings yield between 4% and 5%, how on earth can we all achieve returns of above 10% per year? Well, there are a few simple rules to follow to achieve such returns.
Don’t Settle For Less Than 10%
The first rule is very simple, don’t settle for less that 10%. If you invest in assets that yield less than 10%, it’s impossible to achieve returns of above 10%.
Now, if you have a relatively small portfolio (sorry Warren, I know you’re reading but I can’t write just for you), thus under a billion, you’re pretty flexible with where you can invest. As an example, just check out what Warren Buffett has been doing in the last few years. He has been hoarding cash and buying stocks that yield more than 10%.
In the last 12 months, Buffett bought AAPL at a price to earnings ratio of around 10, thus with a 10% earnings yield. On top of it, back in the fall of 2016, he bought the stocks of the four major U.S. airlines, investing around $2 billion each in Delta Airlines (NYSE: DAL), Southwest Airlines (NYSE: LUV), United Continental Holdings (NYSE: UAL), and American Airlines Group (NASDAQ: AAL). Buffett bought these stocks because their price to earnings (P/E) ratios were all below 10 and some of them had P/E ratios closer to 5. (P/E ratios at Buffett’s purchase: DAL: 7.65, LUV: 10, UAL: 7.87, AAL: 4.77). Such P/E ratios imply an earnings yield between 10% and 20%. There you go!
Be Patient For Opportunities To Arise
The second rule, and it’s closely related to the first rule, is to pile up your cash and wait for an opportunity to show itself. We’re wired in a way where the best thing to do is to take action. If we are sick, we want medicine. If we are hungry, we want to eat. And if we are investors, we want to invest.
Now, if you’re hungry, I suggest you take a bite. If you’re sick, think twice before taking medicine because it’s probably better to wait and see if you really need it. And if you have money, look a thousand times before investing it.
This is pretty much what Buffett is doing. In the last three years as asset valuations have become inflated, he has simply been piling up cash and waiting for good investment opportunities. His cash balance has almost doubled in the last 3 years.
Figure 1: Berkshire’s (NYSE: BRK.A, BRK.B) cash pile. Source: Bloomberg.
Why is he doing this? Well, with $90 billion, it’s hard to find bargains lying around and therefore, he simply waits. In 2016, Apple (NASDAQ: AAPL), airlines, and a few other bargains fell into his lap and so he invested. Sooner or later, opportunities with 10% returns and low risk will arise from somewhere.
You might wonder why he didn’t buy more of the airlines. This leads us to the third rule.
Check The Risks First & Only Then The Potential Returns
What many forget is that each investment is risky and that risk has to be calculated, compared to the potential return—the best thing to do is a probabilistic calculation,—then see how it fits your portfolio, and only then, if all the criteria are met, invest. I’ll focus on the risk part and show how it affects a portfolio.
Let’s say we have 5 similar investments that have a 10% yield. Of those 5 investments, one is going to go bankrupt in the next few years, one will remain flat, and the other three will yield the expected 10%. In such a scenario, the yield isn’t 10% in the end, but only 3.1%.
Figure 1: Yield calculation in scenario 1. Source: Author’s calculations.
Now, to achieve a 10% yield with risker assets, our required return must be higher.
In my scenario—which is an extreme one, but it’s better to be conservative than sorry,—the required returns from all stocks should be 19% to reach a return of 10% after 5 years.
Figure 2: Yield calculation in scenario 2. Source: Author’s calculations.
I’ve given such an extreme scenario on purpose to show that what’s even more important than the return on an investment, is the potential risk because it significantly affect the returns of your complete portfolio.
The goal to find assets that yield more than 10% per year at the lowest possible risk. Or if you prefer riskier assets, then the goal is to find investments where the risk reward is asymmetric and positive, thus in your favor.
That’s it folks! It’s that simple. The only problem is sticking with the three rules I’ve given in this article.
In a market as euphoric as this one, many investors quickly forget to think about risk and only focus on potential returns causing them to buy at crazy valuations, which is good until there’s no greater fool to sell to later. The party will end at some point, and those who bought in euphoria will sell in panic. Exactly at that point, those who have the cash will approach the market in search of low risk, high reward investments. The point is that you only need a few such investments over your lifetime to achieve an amazing investment performance.
To conclude today’s article with the third Buffett example, he bought The Coca-Cola Company (NYSE: KO) in 1988 when its adjusted price was down from above $3 per share to around $2.3. Today, 30 years later, KO’s dividend alone is $1.45, which gives Buffett a 65% yearly return on his investment.
Figure 4: Buffett’s KO investment in 1988 is still giving wonderful returns. Source: Author’s calculations.
Find a few of those in your lifetime, and you won’t have to worry about much!