I read an interesting study published by Thornburg Investment Management that should be required reading for every investor. It is also an invaluable tool for parents wishing to teach fundamental financial principles and skills to their children.
The title of this 4-page gem is "A Study of Real Real Returns" and is available to download in pdf.
"What," you may be wondering, "are real real returns and why should I care about them?"
Inflation, Taxes, & Investment Expenses -- Oh My!
In short, real real returns measure the impact of the three most destructive financial forces on earth -- inflation, taxes, and investment expenses. The point of the study is to understand exactly how much gain an investor is left with after factoring in this terrible trio.
The fantasy world of advertising inundates us with data about investment returns from money market interest rates to stock and mutual fund gains. The financial media and others tout the glories of the latest investing fads such as gold, real estate, or oil. Then we hear from family, friends, or co-workers about their latest investment schemes and tips. Everyone has a success story to tell. On and on it goes, yada yada yada.
Forget the fantasy world. At the end of the day, the only statistic that matters is how much money you put in your pocket. All you care about is the real result to you. That's what real real returns measure.
You Will Be Shocked
Let's consider the 20-year period through the end of 2004. During this time, inflation averaged 3.00% per year. Doesn't sound like much but it adds up. According to the study, here are the real real returns of different investment categories after subtracting the impact of inflation, taxes, and investment expenses.
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S&P 500 Index (stocks) = 7.20%
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Municipal "A" Long Bonds = 3.11%
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U.S Treasury T-Bill = -0.02%
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U.S. Treasury 5-Year Notes = 0.87%
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U.S. Treasury Long Bonds = 1.31%
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Single Family Homes = 1.15%
At 7.20% the returns for the S&P 500 look pretty good and are the clear winner. Other than municipal bonds at 3.11% everything else is anemic. Consider, however, that we witnessed the greatest bull market over the last 20 years which somewhat skews this result. The long-term (1926-2004) real real return for the S&P 500 is 4.96%. The good news is that it's possible to gain ground. The bad news is that it's not quite as much gain as "advertised."
What About Investment Risk?
The above results should give you something to think about when it comes to measuring investment risk and selecting your investments.
Do you think stocks are risky? They are in the sense that their prices are volatile and you can lose your entire investment. (Note - diversification can mitigate much of that risk.) On the other hand, stocks are also the only investment that has gained significant ground over time as noted above. Stocks are king when it comes to building wealth for your future. You're not going to get very far by taking the "safe" route.
Do you think U.S. bonds or your home are safe investments? They are in the sense that they are not volatile in price like stocks, especially on a day-to-day basis. On the other hand, you will just barely make any money on either one as an investment. For example, that nice little house your folks purchased in 1975 for $75,000 must sell today for $273,000 just to keep pace with inflation, never mind the commission for selling it or the maintenance costs and taxes paid over the last 30 years.
It takes risk to overcome inflation, taxes, and investment expenses. But I ask you which is riskier, the possibility that you might lose some money in stocks or the certainty that you will just barely keep pace with inflation, or maybe lose ground, with "safe" investments? Your greatest risk is taking the safe route when saving for the long-term.
What About "Hot" Investments?
This study got me thinking about several "hot" investments being touted these days, particularly gold. So I checked to see how gold has fared over the last 21 years.
Gold closed at $436/ounce at the end of 1984 and currently trades at $572/ounce. That's an increase of $136 or 31%. Sounds good until you look at the real real return. To keep pace with inflation only, the price of gold should be $819/ounce today. That's a 30% loss in buying power at today's price!
Just be thankful you didn't buy gold at its peak of $850/ounce in 1980. The inflation-adjusted price today is $2,015. That means an unfortunate investor at that time would have lost 72% buying power over the last 25 years!
A similar story could be told about oil and other commodities. Thus, despite all the hype about gold, oil, and other commodities, they remain poor-performing investments over time.
Conclusion
When investing consider all the risks, but especially the impact of inflation, taxes, and investment expenses on your investment results. They make or break you in the real world.
Ignore them at your peril.
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