Low Returns Are a Feature of Markets, Not a Bug

Inflation. Most people don’t realize inflation is a relatively new phenomenon. From 1871-1940 the annual inflation rate was basically zero. The total rate of inflation in that period was just 13.2% or around 0.2% on an annual basis. Since then, inflation has come at a much stronger clip, at close to 4% per year. From 1970-2007, inflation was even higher, at close to 5% a year. Since 2008, inflation has slowed substantially, at 1.6%. Although it’s certainly possible nominal returns will be lower, the only returns that matter to investors are their after-inflation figures. If inflation stays subdued, investors could earn much closer to historical returns on a real basis.

Cost matters. Just as real returns matter more than nominal returns when it comes to inflation, net returns after accounting for all costs matter more than gross returns. Costs always matter for investors but fees, expenses and trading will have a much large impact on the bottom line in a low-return environment. Anyone who has studied the stock market from a historical perspective can tell you stocks have earned around 10% a year going back over the past 100 years or so. The problem with this figure is that it does not account for costs, which at one time were extremely prohibitive to investors. Before the mid-to-late 1970s, investors could expect to lose 2% to 3% on each trade they made in brokerage commissions and bid-ask spreads alone. Mutual funds used to carry 8% to 10% sales loads. It was also almost impossible to diversify properly. It’s not what you earn but rather what you take home that matters in the markets.

Someone must lose. Investing is a zero-sum game. In order for one party to win, another party must lose. And after accounting for inflation and costs this means many more investors end up losing than winning. But in a lower-return environment, underperforming can be even more devastating. It’s no fun to underperform in a raging bull market, but even then almost everyone should be making money. If you’re on the losing side of the equation when market returns are muted, your portfolio could go nowhere even as the markets slowly climb. Many investors will try harder by taking more risk when yields are low and valuations are high. There is a higher degree of difficulty in undertaking such a strategy, which will likely lead to very poor performance from investors who don’t understand their risk profile or time horizon correctly.

The other problem with low expected returns is that the path to get there is impossible to predict. We could certainly see a crash or even multiple crashes in the years ahead but markets could simply go nowhere for some time, as well. The bull market could continue for a number of years but eventually we’ll see lower-than-average returns. Investors would be wise to prepare for a wide range of outcomes in that scenario.

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