First the expectations …. While we may not want to admit it in our society, it is probably in our nature to be happiest when there is something to complain about! Which is what makes investing one of the most wonderful and rewarding past-times in the world! As we gaze upon the constituent parts of our investment holdings at any point in time, there is always some part to focus on that is not making us happy. Starting in the Fall of 2008, it was – big time – our equity holdings, which shed anywhere from 30-50% of value in a hurry. They have come back quite a bit in the last 6-8 months – see Trendlines on the Nilson & Co. site. During that time, however, the sage investor needed to seek comfort in the safe, fixed income component of a balanced portfolio. But then—lo and behold! The interest rates paid on new investments fell like a stone, and next it was that component of the portfolio that caused disgruntlement.
Investors tend to focus on the wrong metrics. They believe they are better off when the absolute numbers are bigger. They need to understand the interplay of interest rates, inflation … and taxes! An investor starts by earning a rate of interest called the “nominal” rate. However, if this income is earned in a non-sheltered account, it has to bear income taxes, somewhere between 20% and 45%. Then inflation further reduces the after-tax nominal return, because, while somebody else was using your money so you couldn’t spend it, the cost of those things you deferred buying went up! By the time both taxes and inflation diminish your nominal return, there often isn’t much left as a reward for putting off buying the things you like.
Mathematically, the “nominal” rate of return that investors should expect should include a risk-free “real rate of return” plus a measure of the “rate of inflation” plus, where appropriate, a reward for any additional “risk premium” associated with the uncertainty of a particular investment. In economics, the real return is associated with the reward to deferring the joy of consuming. This real rate of return is calculated as the risk-free nominal rate of return minus a rate of inflation. Historical analysis has suggested that the real rate of return approximates 2-3%. It had been thought, until recently, that this real return was very stable over time; however, we now have evidence that real returns can change substantially over time. Presently the real rate of return is estimated at only around 0.2%!
Let’s get some long term perspective on this “expectation formula”. Dimson, Marsh and Staunton (“101 Years of Global Investment Returns”) provide various historical benchmarks. For instance, the real rate of return in Canada over the entire 20th Century for risk-free short-term treasury bills averaged 1.7%…. and that’s before taxes! The real rate of return over this same period for longer term bonds was only 1.8%…. again before taxes. A devil hides in the details here, however. The 100 year average for treasury bills can be broken into two parts—the first 80 years (only 0.9%) and the last 20 years (4.8%), which is fresher in our minds and experience. The same stats for longer term bonds were 0.3% and 7.9%!
The chart below shows the average annual real return before tax on longer term bonds by decade throughout the 20th Century:
The next chart shows the same returns after (an assumed 30%) tax:
The final chart shows the average annual Canadian inflation rate by decade:
There were four decades in the century of significant inflation. Three of them yielded negative returns over the decade. The average annual inflation rate over the entire century was 3.1%. More recently, the past twenty years (up to the present) have seen two back-to-back decades of low inflation, following two decades of very high inflation. Even when inflation is benign, typically 1-3%, it still packs a long term cumulative impact on purchasing power. A long term inflation rate of 3%, for instance, will halve your purchasing power three times through your entire adulthood until death. Overall, that’s a factor of eight! Today’s 54 cent stamp for an 18 year-old will cost $4.32 by age 90!
Next the strategy …. In a low interest rate environment, after taking in all of these factors, it could be that the safe fixed income component of a portfolio doesn’t serve so much to provide retirement cash flow as it does to provide preservation of capital when the equity markets tank. So, this then begs the question as to where retired investors are going to earn income cash flow upon which to live. A few years ago, the answer lied with trust units; however, these have been harpooned by the government due to the unreasonable tax preference enjoyed by the trust units. The answer now may need to lie in understanding and embracing “total return”, which is the aggregate of cash income plus realized and unrealized gains in a portfolio. Most of the gains will derive from the risk-taking equity component, not the safe fixed income component. And thus, we have the irony that retirees may need to take on more risk by bulking up their equity component to fortify the total return in order to generate cash flow. This comes on the heels of the recent cyclical bath-taking in the equity markets, which has motivated retirees to become less risk-taking.
In closing, we have a client who inherited a substantial sum of money many years ago at age 60 from her deceased father. While she was not sophisticated at investing matters, she did understand inflation and taxes. She engaged us to track portfolio performance in order to give her guidance on how she was doing. Her strategy was that her withdrawals for spending would not erode the real value of the capital (the “base value”) that she inherited. Thus, our annual exercise was to multiply the base value from the start of the year by the year’s inflation rate and compare it to the closing market value of the portfolio. That value ought to be higher than the inflation-adjusted base value. If it was higher, she could afford to increase her discretionary spending in the next year, or leave it “in the pot” for the future. If it was less, she would curtail her discretionary spending until the equation rebalanced in the future.
One must always be mindful of the interplay of returns and inflation.