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Author: imdajunkman Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35367  
Subject: Real Returns Date: 11/6/2006 2:04 PM
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Locicious writes: "I refuse to consider anything over 5% real return, because I consider that wishful thinking."

Loki,

That you choose not to pursue returns that exceed 5% real is no reason that you should attempt to dissuade others from pursuing such a goal. Admittedly, 5% real is a challenge, because it has to be achieved under the following set of conditions:

REAL RETURNS = Gross Investment Returns minus the impact of Taxes, Expenses, and Inflation. In other words, Real Returns are the money that an investor is actually able to keep of the money that his money makes for him.

Now, let's quantify those terms.

Taxes = one's combined Federal and State marginal tax rates.

Expenses = fair-market wages for one's time to manage the investment, plus the costs of office space and equipment, accounting, tax prep, etc., very little of which ordinary investors –-as opposed to a Schedule C filers – can deduct.

Inflation = one's personally-experienced inflation rate (PEIR), not merely the estimate reported by the CPI, which might be lower, higher or the same as one's PEIR, but most likely is the former.


Let's guess a 30% combo tax rate, which is probably a bit low. Let's assess 50 bps against assets under management to cover expenses, which is probably very low if wages are actually paid for one's time. Let's estimate inflation at 5%, which is probably on the mark. Those figures are the “friction” that gross returns have to overcome in order to produce real rates of return. Now do the math. Under that set of conditions, anyone pulling down 15% gross is achieving 5% real. There are many, many investors whose yearly returns exceed 15% gross. True, they are not “average” investors. They are superior investors. But they do exist. They are not financial-world unicorns.

Can an “average” investor using “average” methods achieve returns that exceed 15% gross? No, that is unrealistic. On that point, I would agree with you. The far better strategy, as you suggest, is for them to get their expenses under control. Managing that variable offers them the best chance of success. How likely are they to pursue that path? Ask yourself what the US national savings rate is and what the national consumer indebtedness ratio is and that will provide an answer. The “average” American won't save and doesn't know how to invest. Instead, they prefer to use the ballot box to rob future generations, a process the government abets by printing yet more fait money.

Real returns in excess of 5% might be difficult to achieve. But the ability to achieve them --if need be-- is mere a prudent insurance policy against the certainties of future financial stresses due to present public and private budgetary irresponsibilities. How grim will that future be, and how great will be the shortfalls of “average” investors? I don't know. But finding myself in that situation isn't a risk I'm willing to accept by underestimating the need to develop good investing skills now while there is ample time to learn them. That means I do not set artificial caps on upside returns. The upside is as high as an investor wants it to be IF, IF, IF he or she has the imagination to envision such a goal and then the courage and dedication to pursue it. I don't self-censure self-achievement. What is possible is what each person thinks is possible. As Henry Ford is famously quoted:

“Whether you think you can do it, or whether you think you can't do it, you are probably right.”

Charlie


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