Most investors have in common a desire to see their money grow in “real” terms. A real return, as opposed to a nominal return, is the return generated in excess of inflation. It is the real return that grows purchasing power over time and makes it possible to enjoy greater consumption in the future than one can afford today. For example, if inflation runs at 2% and an investor earns a 5% nominal return, the investor is said to have earned a 3% real rate of return (5% – 2% = 3%) and the purchasing power of their assets has increased. If the investor’s return only matches the rate of inflation, they have preserved their purchasing power but have not grown their wealth in any real terms. If they earn a return less than inflation, they are actually losing purchasing power, which is a position few long-term investors want to find themselves in for an extended period of time.
The reason earning a real rate of return over time is so important is that the real return is what allows individuals and institutions to accumulate enough wealth to afford things in the future, that they cannot afford today. For example, college tuitions, weddings and retirement are all life events that have enormous sticker shock when viewed in today’s dollar terms. Earning a return higher than the rate of inflation is what “fills the gap” between your financial resources today and what is required to fund tomorrow’s larger ticket items.
Growth of $100k Over 30 Years
The question for investors, therefore, is how to earn an attractive real rate of return on your assets. Cash and bonds are traditional asset classes at the more conservative end of the risk spectrum while stocks are generally considered to be on the more aggressive end. As a result of being less volatile, cash and bonds have “rewarded” investors with smaller real returns over time when compared to stocks. In his book, Stocks for the Long Run, Professor Jeremy Siegel indicates that from 1926 to 2006, stocks earned a real rate of return of 6.8% while long-term government bonds earned a 2.4% real return, making stocks the better choice for building long-term wealth as the below chart depicts.
However, stock investors “pay” for that return premia by enduring periodic bouts of negative returns such as what we experienced in Q4 2018. In fact, according to JP Morgan, over the last 39 years the average intra-year correction for the S&P 500 index was 13.9%. Despite these occasional corrections, the S&P 500 still finished in positive territory in 29 out of the 39 individual years, or about 75% of the time. Not every investor needs or wants to take the level of risk associated with an all-stock portfolio because sometimes the drawdowns are deeper and take longer to recover than investors can withstand. As a result, many investors end up holding a mixture of both stocks and bonds to fit their unique risk and return objectives. Increasingly, investors are also including alternative return strategies into portfolios because they typically have lower correlations to traditional stocks and bonds. This can improve risk adjusted returns by potentially reducing overall portfolio volatility across a full market cycle.
In closing, when markets turn down, as they did in the fourth quarter of 2018, it becomes even more important to remind yourself why you are investing and tune out as much of the near-term market noise as possible. Retirement, travel, weddings and education are all very personal and tangible reasons “why” individuals invest. Pension obligations, operational support, future capital equipment needs and maximizing retained earnings are all reasons “why” institutions invest. No two investors’ “whys” are exactly alike, but we all have in common the need to earn a real rate of return to achieve our goals. Long-term success in pursuing those goals is more likely to occur if we avoid focusing on near-term market distractions and redirect our attention instead to why we are investing in the first place. This will allow you to better stick to a long-term investment plan, which is a far better approach than attempting to time every uncomfortable, albeit temporary, dip in the market.