Tales of a Technician: What is a “Good” Annual Return?

Today we’re going to dissect a question uttered by every trader at the outset of their journey. It’s a deceptive query that is far more difficult to answer than some realize. I have opinions galore on the matter and want to lay them out in meticulous detail for two reasons. First, this post will serve as a resource that I can point all future all-star students back to when they ask me this question. Second, like all writing exercises, this will allow me to organize my thoughts and articulate in the best and most informative way possible what I genuinely believe.

The Risk-Free Rate

Perhaps the first thing to recognize is that everything on Wall Street is adjusted for the risk-free rate. Think of it as the rate of return on an investment with zero risks. While it’s true that every investment has some degree of risk, investors view short-term bonds issued by the U.S. Government as virtually risk-free. Specifically, traders use the interest rate on three-month U.S. Treasury bills.

Currently the yield on 3-month Treasuries is 1.77%. Think about that for a second. That means making a 1.77% annual return on your money right now is as easy as falling out of bed. It doesn’t require any brainpower, tactical prowess, or investing wizardry.

Furthermore, the baseline to compare your returns against is not zero — it’s the risk-free rate. If you took a bunch of risks and spent countless hours toiling at your trading terminal only to generate a 4% return in a year where the risk-free rate was perched at 5%, guess what? You didn’t do so hot!

Alternatively, if you garnered a 5% return when the risk-free rate was pinned at 1%, then congratulations! You were compensated for your efforts and duly rewarded for taking on risk.

Your first objective with investing is to beat the risk-free rate!

What’s the Alternative?

A second benchmark to compare your results against is the return you would have captured through passive investing. After all, if you’re going to spend time and energy with trading is it not logical to seek to obtain a better return than buying and holding? Otherwise, why not just park your money in a diversified portfolio of stocks or bonds and go golfing?

If you desire a deep dive on the historical returns of financial assets, I suggest a thorough investigation of Jeremy Siegel’s meticulously researched and immensely educational Stocks for the Long Run. It contains a veritable treasure trove of data.

Without adjusting for inflation, the long-term return for stocks is around 10%. Long-term treasury bonds yielded an average return of 5%. Now, some argue the lofty valuation of our current market coupled with record low interest rates suggest investors should lower their expectations for future returns. I tend to agree with the sentiment, but here’s the bottom line. Over long periods of time, the average annual return of a diversified portfolio has ranged between, 5% and 10%.

Many active traders use that as a target to surpass. Otherwise, again, why all the fuss with vigorous day to day trading and hyperactivity if not to boost your results?

Let’s Not Forget Volatility

Another laudable goal for the active trader is to generate better risk-adjusted returns than buying and holding. When we adjust returns for the level of risk we’re exposed to it essentially means we’re taking into account the level of volatility exhibited by an asset. For example, the long run return of stocks is 10%, but their annualized volatility averages 15%. Bonds, in contrast, have returned 5% per year, while seeing an average volatility of 5%, or one-third that of stocks.

We’ll use stocks as the benchmark that we’re trying to improve upon. Generating better risk-adjusted returns is accomplished one of three ways:

One: Generate the same return (10%) for less volatility (say, 10%)

Two: Generate a better return (say, 15%) for the same volatility (15%)

Three: Generate a lower return (say, 8%), but for drastically less volatility (say, 5%)

If by being an active trader I can dampen the volatility of my portfolio while achieving a similar or higher return than buy and hold, then it’s a win.

A Matter of Strategy … and Skill

Whether it’s realistic to garner a 5% to 10% or 30% to 40% annual return depends on two primary variables: strategy and skill.

Which strategy you implement can have a tremendous impact on setting realistic goals. What’s possible for someone day trading Forex is completely different than a covered call system.

If the name of your game is selling covered calls on a dividend paying stock with a max potential return each month of 2%, then obviously garnering a 30% annual return is impossible. Your best case scenario is a 24% return and even that is unlikely because you’d have to nail your max reward every single month. A gain of 10% to 12% would be more achievable.

For someone swinging a more aggressive strategy, higher returns could be in the offing. The key is to either backtest the system or practice trade it for a spell to determine what’s typical. Then, and only then, can you begin to map out what a realistic return looks like.

The final element is skill. I know of professional traders who can generate mouth-watering annual returns trading leveraged products like Forex. But then, there are also those who try their hand at the task only to blow their account to smithereens. The difference between the two is skill. It’s something that must be developed over time. Through experience, effort, and unwavering dedication.

So what’s a good return?

It’s one that beats the risk-free rate while adequately compensating you for the extra time and effort your putting in. Adjusted for skill and strategy, of course.

For some, it’s 5%. For others it’s 30%. In a year where the stock market crashes 30% if you eke out a small return I’d call it a win. And you can always claim victory when you generate a better risk-adjusted returns than the buy-and-holders.

Last thought. There really isn’t any way to quantify the enjoyment of being engaged, of having a hand in your investments and wealth building. To say nothing of the mountain of development and learning about money, self-control, and risk taking that comes along with it.