Following the post-COVID stimulus hangover in 2022, the bull market has continued to run. One of the key factors was the Federal Reserve’s decision to
The Importance of Real Return in a Low Return World
Published Date : July 21, 2016
A growing topic of conversation amongst many investors is how to properly think about their investment performance within context of the current environment of historically low interest rates and persistently low inflation. To answer that question, it is helpful to look back at the last forty years of history and incorporate that period’s steady decline of inflation and interest rates into an assessment of today’s investment outcomes. A closer look at the so-called real rate of return is necessary to ensure a meaningful comparison can be made between past and present performance.
The historical performance of a portfolio’s nominal return alone does not give a clear indication of how performance measures up in any particular financial environment. A practical way to compare performance over a given time period is to adjust the investment return downward by the inflation rate, typically measured by the consumer price index (CPI), over the same period. Historically, CPI averaged 7.10% per year through the 1970s, 5.60% through the 1980s, 3.00% through the 1990s and 2.50% through the first decade of 2000. From 2010 to the present, the trend continued with the index falling to an average of just 1.60%* per year. It is important to remember that what matters most to us all is not solely how well our investments performed in an absolute sense, but how well our investments have performed after inflation, or the portfolio’s real return. To illustrate real return, imagine a diversified portfolio that averaged an annual total return of 8%, net of fees, over the decade of the 1980s. After deducting inflation of 5.6% (CPI), the average annual real return would equate to 2.40% over that time period. Imagine the same diversified portfolio averaged an annual total return of only 4.90% from 2000 to 2010. It would have also earned a real return of 2.40% annually (4.90% less 2.50% CPI).
For many present day retirees, their investing history began in a period of higher yielding fixed income vehicles. Not to be overlooked, however, is that higher interest rates or inflation during that time period eroded a sizable portion of the nominal return. While returns may appear more muted today when judged against higher nominal returns of the past, it is important to remember that current returns must be compared against today’s strikingly lower rates of inflation. Investors who incorrectly fixate on nominal returns, and find today’s low yield environment challenging, must avoid the temptation to deviate from their long-term investment plan. Over time, the interest rate and inflation environment will normalize and nominal returns will rise again. In the meantime, reaching for yield in riskier or non-traditional investments in an attempt to replicate past nominal returns is a strategy we would not endorse.
As the global economy continues to expand, it is likely that inflation and interest rates will rise as well. Over time, investment returns will normalize accordingly. In the meantime, one way to keep current investment returns in perspective is to consider your returns relative to inflation and recognize that your overall purchasing power continues to expand, even though the total return environment over the last year or two is more subdued.
* Consumer Price Index results – All Urban Consumers, Bloomberg
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