Returns through the windshield, not the rear-view mirror

What kind of returns are you expecting over the next 5 to 10 years?

Most people look at history as a guide to answer such a question, but is that really the right approach?

The Wall Street Journal published a good article last week on just this issue.

Most investors expect 5-10% returns because that’s what they’ve seen in the past.  Those same investors thought 15-20% returns were possible in 2000.  Not so much.  They also thought housing prices would go up much faster than inflation back in 2006.  Wrong, there, too.

Why can history be a poor guide?  Think about throwing a ball into the air.  If you project the first part of its upward flight into the future, you’d think it would keep going up.  But, that doesn’t factor in good ole gravity.

The same is true with investing.  You can look at the past, but you have to factor in where things started, where they ended, and what forces may cause projected trends to change.

By looking at such underlying factors, I think you can expect 1% to 7% returns over the next 5 years, 4% to 8% returns over the next 10 years, and 6% to 8.5% returns over the next 20 years.

Keep in mind, those numbers include inflation, so you have to subtract around 2.5% from each figure to get the real return (what your dollars can actually buy in the future).  And, yes, that means we could experience negative real returns over the next 5 years.

Those numbers aren’t terrible, but they aren’t what most people are expecting (especially after a year when the S&P 500 was up over 32%!).

If you need to drive from Colorado Springs to Denver and need to arrive at 4 pm, you can’t get there by leaving at 3:30 pm and driving 120 miles per hour.  Assuming the wrong rate prevents you from reaching your destination on time.

The same is true with investing.  Assuming the wrong rate of investment growth will cause you to save too little, and not have enough to retire when you want.

To plan a safe retirement journey, plan accordingly.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Returns through the windshield, not the rear-view mirror

Investing: 3 part harmony

Investment returns seem mysterious to most. You buy one investment and it takes off; you buy another and it tanks; you buy a third and it goes nowhere. Why? It seems more random and unpredictable than the weather at times.  

The underlying reality is more simple than that, though.  Investment returns can be broken into three parts and analyzed individually. Understanding that three part harmony makes investing seems much less mysterious and more practical–and so it is.

Investment returns consist of:

  1. dividends relative to price paid
  2. underlying earnings growth
  3. change in the multiple to underlying earnings

The dividend seems like the most straightforward part of investing returns, but many people seem to overlook the importance of it. What matters is the dividend relative to the price paid over the full period of investment. If that dividend is eliminated (like banks in 2009), shrinks (Real Estate Investment Trusts) or grows (Johnson and Johnson), that can have a big impact on your return. It’s important to understand the dividend yield as well as the sustainability of that dividend (whether it will grow or shrink).

The second element, earnings growth, is (in my experience) the hardest to predict, and has  the second largest impact on returns. If earnings grow while you hold an investment, then you have a nice tailwind that can allow you to generate good results (Apple). If earnings shrink (Best Buy), or even tank (Citigroup), it probably won’t matter what price you paid or dividend yield you start with, your investment results are likely to be unsatisfactory.  

Earnings consist of underlying sales and profit margins (or book value and return on equity in the case of banks, insurance companies, etc.). If sales grow and margins are stable (Wal-Mart), then earning will most likely grow. If margins grow and sales are stable (IBM), you’ll likely experience earnings growth. If margins and sales tank because technology has become obsolete (Blackberry, anyone?), earnings shrinkage will be a big headwind to your results.

The third element, change in multiple to earnings, is the most difficult for people to grasp and is likely to have the biggest impact on return. The multiple people are willing to pay for earnings, which is frequently expressed as price to earnings ($10 per share stock price, $1 per share in earnings, 10x price to earnings multiple), is a reflection of how market participants think of a company and its future prospects. If people think very highly of a company (Amazon), they may be willing to pay 20x or more on earnings; if they think poorly of a company and its prospects (Xerox), they may be willing to pay only 5x earnings.

Market sentiment towards companies changes a lot over time. When people become despondent with a company, it can trade very low to fundamentals; when people become euphoric, a company can trade at very high multiples. Whereas one can analyze and predict dividends and earnings based on underlying evidence, multiples are more likely to be a result that must be judged and reacted to rather than predicted. Buying at a low multiple and selling at a high one gives a tremendous tailwind to investing results.

When you put together multiple change, earnings growth and dividend yield over the life of an investment, you have the three parts of investment return. By analyzing those three parts, you can understand why your investments do well or poorly, and then make adjustments to your investment process. The three part harmony of good returns requires a keen understanding and mastery of all three parts.  

Investment results can be clearly understood if you take the time to do so. Such an effort removes the mystery and reveals an understandable system that can be used to produce good results. This may not sound as exciting as shooting from the hip in hopes of a big win, but good results over time create great wealth, and that’s as exciting as can be.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Investing: 3 part harmony