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.