Wednesday, October 20, 2010

Modest Investment Returns are Better than They Appear

We frequently hear that investors need to lower their expectations about investment returns. Experts say that it just isn’t realistic to expect double-digit average returns over the next decade or more. However, if we put the focus where it belongs on real returns, the future looks brighter.

The latest expert to counsel lowered expectations is TD Bank's Chief Economist Don Drummond as quoted by Canadian Capitalist. Drummond suggests realistic expectations are 2% inflation, 6% to 7% returns for stocks, and 3% to 4% returns for bonds.

These predictions are presented as very modest returns when, in fact, they are quite good. The important thing is to focus on real returns, which are returns after subtracting out inflation. Real returns of 1% to 2% for bonds and 4% to 5% for stocks are nothing to dismiss. I would happily accept this result.

Investors get themselves into trouble when they focus on nominal returns, which are returns without subtracting out inflation. Let’s look the decade starting in 1972 as an example. The TSX Composite index had an average gain of 11.7% per year. This may sound much better than 6% to 7%, but we must account for inflation. During this decade inflation was very high. The average real return on the TSX Composite during this period was only 2.2% per year. I’d rather have 4% or 5% real returns.

While an investment of $100,000 in the TSX in 1972 grew to $303,000 ten years later, its purchasing power grew to only $124,000. What’s worse is that an investor who had to pay say 20% taxes on the yearly gains actually lost purchasing power over this period.

Put another way, an investor who spent the gains each year thinking he was preserving his capital would have seen the purchasing power of his $100,000 in 1972 drop to only $41,000 a decade later.

I’m sure that Don Drummond and Canadian Capitalist understand all this very well, but they also know that the majority of investors tend to focus solely on nominal returns. Investors need to stop moaning about low nominal returns and start focusing on real returns.

10 comments:

  1. While I agree that 4% real returns from stocks is quite good, investors in the 90s earned 8% real returns from stocks and 7% in the two decades until the millennium. I think many investors are still anchoring their expectations to those returns.

    Also, in all fairness, I should mention that Mr. Drummond did mention that these returns are quite good for a low inflation environment. I didn't write fast enough to note that down :)

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  2. @CC: I'm with you on preferring real returns of 8% rather than 4%, but I'll be content if real stock returns over the next 20 years are positive.

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  3. I guess a corollary is that inflation makes people feel good with regards to stock market returns. As an investor, I have a goal of attaining $x by such and such a date. High inflation makes it easier to achieve that goal.

    I don't usually frame it like this: I want to have $x by the end of 2015 in 1990 dollars... but I probably should!

    In the Austin Powers movie, the villian is cryogenically frozen from 1967-97. His ransom for some new outlandish plot is one million dollars. His henchmen start laughing at him, since one million dollars is such a small amount in 1997 compared to 1967, so he changes it to one billion dollars

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  4. Mike
    Interesting. Would it be correct to say inflation adds another element of uncertainty to the "stocks for the long run" view? People investing over the next 10 to 30 years cannot know in advance if inflation will be low enough to give them a decent real return?

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  5. @Gene: The mathematician in me finds it funny that a factor of 1000 is used to compensate for 30 years of inflation. I suppose this wouldn't be enough in some countries, but it definitely overshoots the mark in Canada and the U.S.

    @Larry: Inflation is an additional uncertainty, but I'm not sure that it really adds to volatility. As inflation rises, company revenues and profits tend to rise as well. I would be surprised if real stock returns were much more volatile than nominal stock returns, but I don't know for certain. My approach is to focus on real returns and not worry too much about inflation when investing in stocks.

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  6. Interesting discussion. Since close to half the stock market returns are from dividends, I prefer the dividend growth investing strategy. If a company is annually raising their dividend by 5% (not a stretch), you will likely receive 8-10% returns on your money in the long run. Dividend growth plus yield will typically equal your overall expected return.

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  7. A great reminder to always think in post-inflationary dollars.

    I too, would gladly take 4-5% from stocks. If I got anything more from my dividend-payers, heck, even better.

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  8. I think the biggest problem with investment return expectations is that many pension funds are counting on rates of return that are much higher than they will be able to deliver. Many of them are based on return assumptions like 7% real. If that doesn't materialize, they'll have to adjust payouts or increase premiums for contributors.

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  9. @Balance Junkie: I wouldn't want the headaches of trying to run a pension fund. At least an individual can just choose to work an extra couple of years before retirement or reduce planned expenses if investment returns disappoint.

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  10. Inflation being high doesn't mean that stocks won't return their historical amount in real terms.

    Remember inflation is just too many dollars chasing two few goods.

    The value of anything that isn't cash should increase (all other factors being equal) by the inflation amount.

    So, just because stocks (and everything else) is priced in dollars/whatever currency, that doesn't make it equivalent to that cash, a share is a part ownership in the company will just go up with inflation, all other factors being equal.

    Unless you are heavily invested in holding companies that have all cash/fixed income investments, inflation isn't a friend or an enemy.

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