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Thursday, January 13, 2011

Not so great expectations

If I've said it once, I've said it a million times: for most investors long term returns are what count most--not what the stock market will do this year or next.

And yet, most investors over-focus on short term prospects.  That's probably why they get lousy investment results over the long run and brilliantly high (and then low) returns over the short.

It's not the returns you could have gotten that count, it's the returns you actually get.

But, long term prospects don't look that great right now.  By my reckoning, the S&P 500 is set to deliver slightly more than 3% annualized returns over the next 5 years.  With inflation of 1-2%, that's a real return of only 1-2%. 

Do investors have great expectation when they should have realistic expectations?  I believe so, and they very much want to believe the market commentators who promise 10% returns this year.

Don't get me wrong, we may see 10% - 20% returns over the next couple of years.  It's not just possible, it may even be likely! 

But, those returns will be given right back over time.  The market will regress to the mean, as it always does, and investors will once again be right back where they started, or lower.

The way off this treadmill-to-nowhere is to start with realistic expectations and then pick investments that can solidly beat them.  But, this takes time and effort, so most investors prefer the strategy of hope.

Hope, let me be clear, is NOT a strategy (a mantra I learned to repeat from my time in the Air Force).

Can you find investments right now that will beat 1-2% inflation-adjusted returns?  Yes.  Will bonds that yield 3% do it?  Most likely not.  Will stocks of companies with solid franchises, strong balance sheets, reliable cash flow, meaningful dividends, selling at low prices to fundamentals do it?  Most likely.

Will such investments beat the market every month, quarter, or year?  Almost certainly not.  That's why most people don't own them!  But, after the market goes up and then down, or down and then up, or sideways for years, or whatever else could happen, such investments will almost certainly win.

Just look for investments in companies that have pricing power--the ability to raise prices with inflation.  That will take care of that nasty 1-2% (or likely more) inflation. 

Then look for businesses that grow with the economy--they sell products or services that people can't do without.  That will likely give you 3% real returns. 

Then look for businesses that aren't financed with tons of debt--they are the ones that could go bankrupt in tough times. 

Then, look for businesses that can and do pay out a portion of their earnings in dividends, and make sure they can continue to pay even if business conditions become poor--they are the one's whose dividends are covered easily by earnings in good times and bad.  That should give you a 2-4% return while you wait for the market to regress to the mean.

Then, make sure you don't pay too much.  If you pay a high price to fundamentals, you're doing the same thing as buying the S&P 500 and locking in 1-2% real returns.  If you pay a low price to fundamentals, you're protected against the downside and likely to benefit from the 1-2% inflation, 3% underlying growth, and 3% dividend specified above. 

If you do all that, you should lock in 6% real returns instead of 1-2%.  That may not blow your hair back, but it's a lot better than riding the roller coaster up and then down again for the 3rd time in 15 years.

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.

3 comments:

herdingcats said...

Hey Mike,

Always enjoy your updates. You manage to be realistic and inspiring at once which is rarity in most financial reporting.

Much appreciated.

Judy Murdoch

Anonymous said...

A number of great concepts. Very well considered

Anonymous said...

One of the best articles We've ever looked over with this issue. Thank you!