Calling BS on high rates of expected return

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Calling BS on high rates of expected return

Tuesday, July 21st, 2009 | Economics |

I’ve long since been disabused of notions that investments will consistently 8% or more annually, year in and year out. This is the best illustration I’ve seen of why those claims are absurd.

Let me demonstrate the impossibility of high returns over long periods of time. Peter Minuit bought Manhattan Island from the Indians in 1626. Supposedly, he paid them in beads and trinkets worth about $24. We all figure Mr. Minuit was pretty shrewd, and had the best of the bargain. Well, smart as he was, he wasn’t smart enough to get a 10 percent return on his money. Had Peter taken that same $24 and invested it at 10 percent, today, instead of having just the real estate we now think of as New York City, his fortune would amount to some $34,000,000,000,000,000! That is $34 quadrillion, or approximately the value of the total output of goods and services of the United States over the next 17,000 years! Assuming a constant GNP, of course.

In short, not one dollar of capital that existed in 1626 has compounded itself at 10 percent in the intervening period. Not one dollar. If it had, today it would be worth over $1 quadrillion, an amount greater than the value of all the man-made wealth in the world. No capital has ever compounded itself at 10 percent for more than a few decades.

Why can’t wealth grow at 10 percent annually? Because it is not being created that fast. As we noted in the first chapter, wealth is the real things that man creates from nature’s raw materials. The growth of real wealth is limited by man’s ability to produce, and is reduced by his consumption. Real growth is the amount left over at the end of each year that is added to his stockpile of real goods. Man cannot increase wealth fast enough to meet his consumption needs and have 10 percent left over each year.

From AlphaStrategy (PDF link), a 1980 book about wealth preservation. I’ve mostly skimmed it, but I like and agree with the part about buying consumables that starts on page 69. Like I’ve said before, the only costs to this strategy are that buying things in bulk takes up space (we’re adapting by making and finding space) and that we have to invest a little money up front. The upsides are lower prices from buying in bulk, fewer trips to the store, fewer occasions when we find ourselves without an item, and protection against future price increases or unavailability.

Tags: buy it cheap and stack it deep

4 Comments to Calling BS on high rates of expected return

Richard Wisner
July 22, 2009

Hi, Les,

Please take a look at James Glassman’s and Kevin Hasset’s book “Dow 36,000″. While the title has elicited unending derision, the treatise is sound and history bears out their arguments.

Actually 10% - 11% is the historical norm for stock market returns, as I recall after reading their book years ago. I believe it’s still gonna be true when even after the dems are gone from office and we return from the depths of socialism.

These gentlemen are tops in their field and are not selling anything. Here is Glassman’s financial news blog: http://www.american.com/

Thanks again for your excellent news and commentary blog.

RSW

Les Jones
July 22, 2009

“While the title has elicited unending derision, the treatise is sound and history bears out their arguments.”

This morning the Dow is at 8,937. I don’t see how history has borne out their arguments.

Will the Dow eventually reach 36,000? Sure, if you give it enough time and inflation. The high returns usually quote for the stock market are for specific periods and fail to factor in inflation.

Go here for a graph of Dow returns after being adjusted for inflation. The real (inflation-adjusted) return is around 1.64%. There was an historically enormous spike beginning around 1996, but the Dow is now returning to its mean.

aczarnowski
July 23, 2009

I’m getting the impression there are no investments which can outrun inflation these days.

If true, what, we’re all doomed to work backwards forevermore? Or, at best, buying commodities like gold/silver so we can (almost, after transaction fees) stay wealth neutral?

Les Jones
July 23, 2009

I’m convinced by my financial guru (Eric Janszen at itulip.com) that gold will go up significantly. His price target is $2500/ounce. Looking at historical ratios gold at $950/ounce is still underpriced relative to the stock markets.

Beyond that, gold is an excellent hedge against accelerating inflation, which I expect we’ll see in the next few years.

In general, whenever the U.S. is in a war it’s probably a good time to have some gold.