You should measure the risk of an investment as the potential loss of purchasing power over the holding period.
Read: The REIT solution
4 reasons to choose productive assets
- Average annual real return of 6.6% over the past two centuries
- Stocks haven't had a negative return in any 20-year period
- Dividends cover the rate of inflation
- Stock returns adjust for long-term inflation
In other words, investors forgo consumption now, so they can consume more at a later date. This means you should measure the risk of an investment as the potential loss of purchasing power over the holding period.
Take currency-based investments, such as GICs, money-market funds and bonds. These are typically viewed as some of the safest assets available.
Investors are happy as long as they receive their timely payments of interest and principal. But these investments can be far more harmful to your purchasing power than they appear.
When adjusted for inflation, these so-called safe investments yield a negative real return.
The age-old adage attributed to the late Wall Streeter Shelby Cullom Davis, an American investment banker and philanthropist, still rings true today: "Bonds promoted as offering risk-free return are now priced to deliver return-free risk."
During times of uncertainty, investors also tend to flock toward assets such as gold. But the price of gold jumped to a record high of $1,900 an ounce in September 2011, during the latest economic crisis.
Although it has since retreated to just above $1,600 an ounce, gold's rise has been fuelled by the world's feeble economic state. As central banks print dollars with the intention of stimulating their economy, investors fret the implications of currency devaluation, so they're moving cash into hard assets as a safety net against inflation.
Gold is an inert asset, and although it makes beautiful jewelry, its practical uses are limited. In fact, 75% of the world's gold supply sits idly and at great expense in bank vaults.
Read: Is gold over?
Yet, unlike other investments, gold produces no cash flow and pays no dividend. And despite its rise in the latter part of the last decade, its record of past return isn't impressive (see "Gold's unimpressive history," this page).
So where should investors look for real returns?
Productive assets. Whether a farm, real estate or a business, these investments produce output that retains purchasing power.
Stocks — which represent an ownership share of the underlying business — have beat every other asset class, producing an average annual real return of 6.6% over the past two centuries. So the same $1 invested (while reinvesting all your dividends), would yield $669,500 in purchasing power today.
How did we come up with that number? The historical dividend yield is 4.44% (currently, it's 2.1%) so the 6.6% average annual real return over the last 210 years is made up of dividends (approximately 67%) and real growth (approximately 33%).
In other words:
› $222,943.50 earnings growth › $446,556.50 dividend reinvestments
Given this information, why are many investors still so averse to investing in stocks? Over the last few years, the markets saw an increased allocation to fixed-income funds.
It's time to look ahead. Despite the ups and downs of the stock market, and the outperformance of other asset classes over shorter periods of time, it's better to be invested in quality productive assets over the long term, instead of weaving between asset classes.
Stocks still a good choice
Even though we've just come out of a lost decade for equity returns, there is no 20-year period where stocks had a negative return. The same isn't true for bonds.
And since the S&P 500 was founded in 1957, the constituents' dividends alone have covered the rate of inflation. Also, just like companies who produce purchasing-power-retaining products, stock returns also adjust for inflation over the long term.
Today's corporate earnings and profit margins are at all-time highs. Companies are sitting on record cash reserves, the U.S. GDP is 50% larger than it was a decade ago, and global GDP has doubled during the same period, according to data from the World Bank.
Yet if we were to graph a straight line representing what the 6.6% long-term real-growth stocks have provided, we'd be plotting our point about 15% below trend. This means the market has a ways to go to reach what we would consider a fair valuation.
Quality productive assets provide better value, and if clients don't overpay, can deliver superior purchasing power for many years to come.
Gold's unimpressive history
Back in 1980, amid fears of war and inflation, gold hit a high of $873 per ounce. But when those fears subsided, the price of gold crashed. It retreated to $500 an ounce mere months after hitting its peak, and fell to $300 by 1982.
It then took 28 years for the price of gold to return to its 1980 peak.
The research of Jeremy Siegel, a professor of finance at the Wharton School of Business, reveals that between 1802 and 2012, gold has only produced a real return of about 0.7% per year. Put another way: had you invested $1 in gold in 1802, you would have approximately $4.35 of purchasing power at your disposal today.
Yet had you invested in U.S. government-issued bonds over the same period, you would have fared much better. A $1 investment would have become $1,180 of purchasing power today, and had you chosen to reinvest the interim interest payments received, you would have more than $1,600 of wealth at your disposal.
Susy Abbondi is an equities analyst at Duncan Ross Associates.
Originally published in Advisor's Edge Report
Read this article and full issues on the iPad - click here.