(Cross-posted from Mish Board, due to fixed-income data at the end.)For Long-Term Investing Plan,Measure Real-World ReturnBy E.S. BROWNING Staff Reporter of THE WALL STREET JOURNALFebruary 6, 2006; Page C1...In that real world, inflation, taxes and trading costs bite huge chunks out of the indexes' real returns, making them far lower than they seem.If you had invested one dollar in the S&P 500 back at the start of 1926, for example, you would have had $2,655.73 at the end of December 2005 -- a very nice gain. But after removing the effects of inflation, taxes and trading expenses, that $2,655.73 would be worth just $46.59......If you adjust for inflation (not even considering taxes and fees), the Dow would have to rise to 13723 to reach the real current value of its 2000 high......anyone who held funds in a money-market account in recent years lost money in real terms, because inflation often has been higher than money-market interest rates. The attraction of money-market funds, of course, is that the principal hasn't fallen, as it can if you own a stock.All this isn't to say that stocks are a bad investment, relatively speaking. In fact, controlling for inflation, taxes and expenses shows even more clearly that stocks over the long term tend to rise faster than other investments, including real estate....Studies show that most mutual-fund managers fail over the long term to beat the indexes. Their shortfall, in fact, tends to resemble their expense levels. -- End of articleStocks' real growth rate over 80 years is 4.94%. The 50-year mean of the real rate of the 90-day T-Bill is 1.36%. The 50-year mean of the real rate of the long-term T-Bond is 2.39%.The 50-year mean of the real rate of the 90-day T-Bill has recently reverted to its 50-year mean, after about 5 years of below-average real yield. It is almost exactly the same as the real rate of the long-term T-Bond, as we all know, from the flatness of the yield curve. In the past, this has generally been quickly followed by a cut in short-term interest rates.http://www.martincapital.com/chart-pgs/CH_mmnry.HTMThis compares to a current yield of not quite 2%, for 5-year TIPS. The implied rate of inflation, for 5-year TIPS, is 2.53%. The ratio of real yield, (80-year) stocks/ (current) TIPS, is currently about 2.5.There are no fees or commissions for buying TIPS, from Treasury Direct or Fidelity, at auction time. You would have to adjust your actual results for your own stock trading costs.What will future stock growth rates be? What will future inflation rates be? What will the real rates of bonds be? What is your tolerance for risk?Your answer to these questions will help determine which investments are right for you.Wendy
“What will future stock growth rates be? What will future inflation rates be? What will the real rates of bonds be? What is your tolerance for risk?Your answer to these questions will help determine which investments are right for you.” Wendy,Which of those four questions can be answered by the “average” investor? I'd say, not a single one of them. No matter how important it might be for them to answer those questions (as a means of rationally planning their financial lives), most investors have neither the interest nor the means of creating more than very bad guesses. Blame the schools, blame the financial industry, blame the investors themselves. But the sort of financial literacy needed to deal with any of those questions in meaningful ways is very uncommon, nor can precise answers be given to the first three except by charlatans. Peter Lynch used to say that “If I spend more than 15 minutes a year thinking about where the stock market will be in a year or whenever, I have just wasted 10 of them.” Contingency planning, OTOH, can be done and has to be done. But that's as good as it gets. Nobody but nobody can predict the real rate of return for any investment. Nobody can predict any economic or financial fact. What they can do is extrapolate from past trends and create a range of scenarios which they can weight (equivalently, do Monte Carlo simulations or similar), but those kinds of modeling skills are beyond the interests and means of the average investor, which illustrates the extent to which the working people of this country have been duped by accepting DC retirement plans for DB retirement plans. They have been entrusted with assets to manage for themselves, but they haven't been trained to manage those assets. Charlie
WendyBG writes:<< Stocks' real growth rate over 80 years is 4.94%. The 50-year mean of the real rate of the 90-day T-Bill is 1.36%. The 50-year mean of the real rate of the long-term T-Bond is 2.39%.>>I think you are comparing apples and oranges.The "AFTER TAX" real return for stocks over 80 years is 4.92%.The "BEFORE TAX" mean real return for the long-bond over 50 years is 2.39%.Since taxes are paid on nominal rates, then we can assume the mean AFTER TAX real return for the long bond would be somewhere around 1.00%.So equities have a real return of approximately 5 times treasuries.During the decade of the 70's, I have seen how inflation can devastate a fixed income portfolio. With equities you have two advantages. 1) the after tax real return is 5 times greater. 2) dividends and earnings eventually rise with inflation and in time your investment will recover in real terms.<< What will future stock growth rates be? What will future inflation rates be? What will the real rates of bonds be? What is your tolerance for risk?>>With a real 4% risk premium for equities and time on my side (no maturity date), my stock portfolio is the investment that allows me to sleep at night and NOT worry about the above questions. My short-term fixed income portfolio is there to stabilize my equity returns and add some current income. For me, bonds/cds/mm are more like insurance than an investment. Stocks are the REAL long term investment.
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