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Some Modern ROR versus RORR Musings
By Rick Kahler MS CFP®
http://www.KahlerFinancial.com
Is there anything more important than the overall rate of return you earn on your investment portfolio?
Yes, there is. It’s the real rate of return.
Past Half Decade
Over the past five years, even diversified portfolios have earned relatively low returns. Many investors are fearful that this has significantly reduced the income they can expect to receive upon retirement.
To see whether that fear is justified, let’s look at some numbers. Based on a model portfolio I follow that holds nine different asset classes, the average return for the past three years (after all fees and expenses) was 2.45%. The five-year return was a little better at 2.67%. However, the seven-year return was 5.62%.
If an expected long-term (10 years or more) overall return on the same portfolio was 5.00%, at first glance it appears the portfolio slightly exceeded its expectation for seven years, but fell considerably short the last three and five years.
Now – Take a Second Glance
But, if there is a first glance, you know there is a second glance coming. And that second glance highlights a seemingly obscure fact that changes the picture considerably. In every future return expectation, there is also another estimate that rarely is mentioned, but which is as important as the rate of return. This is the rate of inflation.
While the long-term expected overall return was 5.00%, the long-term expected rate of inflation was 3.00%. That means there was an expectation the investments would earn 2.00% above the rate of inflation.
This is known as the real rate of return (RROR) and it’s far more important than the overall rate of return.
For example, if the projected inflation rate was 4%, the expected real rate of return would have been 1%. At a projected inflation rate of 6%, the real rate of return would have actually been negative.
Most financial planners base their projections of a client’s retirement income on the real rate of return. A real rate of return of 2% is very common.
The Real Rate of Return
Taking into account the real rate of return, what has actually happened over the past three, five, and seven years? Overall expected returns have definitely been lower over the past three and five years. So has the rate of inflation. While the estimated inflation rate was 3.00%, the actual inflation rate was significantly lower, at 0.78% for the past three years and 1.03% for the past five. Subtracting these numbers from the overall rate of return (2.45% for three years and 2.67 for five years) gives us the real rates of return: 1.68% and 1.64% for the last three and five years. Compared with the estimated real return of 2.00%, this is slightly lower but still close to hitting the target.
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Looking at the seven-year real rate of return, things go from “ok” to “phenomenal.” While the overall rate of return of 5.62% was higher than the expected return of 5.00%, the inflation rate was 1.03% instead of the expected 3.00%. This resulted in a real rate of return of 4.59%, more than double the expected real rate of return.
Bottom Line
The bottom line is that those investors who have been in the market for seven years will have more to spend in retirement than previously projected. In investment circles, this is called a home run.
For physician investors discouraged by recent overall return numbers, a second look might give you cause to cheer up. If you’ve invested in a diversified portfolio, rebalanced, and stayed the course during market crashes, things may be better than they seem.
Assessment
Thanks to one of the lowest inflation rates in modern history, you could be further ahead than you thought.
Conclusion
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Filed under: Investing, Portfolio Management | Tagged: rate of return, real rate of return, rick kahler |
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Double Your Return … What I Learned!
On May 27th, 2005, I started MZ Capital Management as a hedge fund with “Double Your Return” as my first marketing tagline.
Shortly after the Enron debacle, Congress passed the Sarbane Oxley Act, which requires company insiders to report their trades to the SEC electronically within a day of the trades taking place. I created a computer program to query the SEC’s database in real time. So as soon as, for example, IBM’s CEO reported that he bought 10000 shares of IBM, I would know it right away.
On a typical working day, I would be half naked lying on the beach of Palm Beach and I would get a text on my dumb cell phone (sent to me by my computer working hard on my desk.) I would call my broker right away to follow the trade. Then the news would get to the WSJ one week later, the price of IBM would pop and I would sell for maybe a 5% to 10% gain.
Just like that I was making 20% to 30% return every month! I calculated that at this rate of compounding, I would become a trillionaire in about 10 years. I was so confident, I started the hedge fund to share the wealth.
Lest you don’t know yet, I did not become a trillionaire hack, not even a billionaire. So what went wrong?
A few months into my hedge fund, I noticed a small website, where for a $20 a month subscription, you could also get insider information in real time. To find out if the website was as good as my software program, I signed up to become its first paid customer. I even become friends with the founder, Josh Hong, a young man from Korea.
I found out the website is only one second slower than my program in getting the insider information. This had the potential of killing off my hedge fund business, because previously I had had one week of advanced knowledge. Suddenly, it was only one second, not nearly enough time to place trades
So I called up Josh, because by then we were friends. I told him his website was slower than my program by one second. I asked him to slow his website down by a single minute to give me time to place advance trades.
A week later, he called me up saying excitedly, : “Michael, I found out why my website is one second slower than your program! Now I can shave that second off!”
Josh later introduced me to his sister. He wanted me to date his sister but he wouldn’t let me have any information edge.
Within a year, websites like Josh’s proliferated. A lot of times, prices would have jumped before I could place trades. I lost whatever information edge I had.
This experience taught me an important lesson: No money manager or hedge fund can have a permanent edge since the market is in a relentless drive toward efficiency. I removed the “Double Your Return” tagline and never look back since.
Michael Zhuang
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