Inflation? Inflation! Yes, that pesky 9 letter word that no one has really thought about since the 1980s (In the U.S. at least).
I wanted to take a look at what it really has done to investments over the last 88 years…especially since a lot of great investors (Bogle, Arnott, Asness, Faber, Ferri, Swedroe, Grantham…etc) are predicting future returns in the U.S., at least over the next 7-15 years, to be fairly muted in comparison to historical averages. (Full disclosure: I agree)
When we look back at the last 40 years, both stock and bond returns were awesome, especially compared to the 40 years prior.
But the numbers that most people compare are just nominal returns. Most investors focus on these nominal returns for a couple reasons:
- It is easier to track.
- Adding inflation into returns is annoying.
- Inflation impacts people differently (Rent v. Owning, Child Car Costs, Medical Costs, etc.)
- It makes return %’s smaller which is no fun.
- You can’t predict forward inflation (Ask any central bank about that).
The catch of course, is that we eat real returns, not nominal returns, so when looking over long-time periods in history, it is important to factor in inflation.
I don’t think everyone should track real returns constantly… it is a pain as we mentioned above and inflation is going to affect all of us to different degrees when it comes to our traditional stock and bond holdings. So what is the point of muddying up the waters? I personally don’t think it is necessary in “most” cases to go that extra step…
HOWEVER, in regards to this conversation, I think it is a very important number to look at to see if the last 40 years really were that much better for investors.
To the excel…
Quick Note: This should have no bearing on any investment decisions, it is just to illustrate an example and to provoke some thoughts.
I pulled up a few tables of data from 1928 – 2015:
1. S&P 500 Annual Total Returns
2. 10 Year U.S. Treasury Annual Total Returns
3. 10 Year U.S. Rates by Year
4. Yearly Inflation
I then looked at 3 time frames:
- The entire 1928 – 2015 period
- 1928 – 1971
- 1972 – 2015
Why those break points?
Well to keep things simple, it’s an even split of 44 years on each end AND 1971-72 is right around where high inflation starts to kick in so it creates a unique time period to compare against. Remember, prior to the 1970s, U.S. inflation and by extension, the 10 Year Treasury yields, were range bound for many decades (something that could happen again). It’s also unique in that, because of the inflation in the 1970s, it created a very special time period for Fixed Income i.e. fairly high returns compared to history (I don’t think there were too many PIMCOs around before the 1970s).
Using the data, I spit out some answers based on 6 (100/0, 80/20, 60/40, 40/60, 20/80, 0/100) different Stock/Bond allocations:
1. Nominal CAGR
2. Standard Deviation (Volatility)
3. Nominal Sharpe
4. Avg Inflation for the Period
5. Real CAGR
6. Real Sharpe
The final product:
Some fun conclusions:
1. If you look at the Real Returns of a 60/40 from 1928-1971 versus 1972-2015, there is NOT a huge difference (0.49%/yr) compared to the nominal returns in that period (2.58%). The higher stock portfolios actually had HIGHER real returns in the early period, despite much lower nominal returns.
2. If expected returns are to be lower in the future, which they may or may not be, it’s important to remember what the inflation is during this period. 20% annual returns during a period with 15% inflation is going to have a very similar impact on an individual who earns 10% annually with 5% inflation. Try to not get hung-up on just historical nominal returns.
3. Everyone expects rates to rise at some point back to the levels seen in the 70s, 80s and 90s…But what if they don’t? What if the next 40 years are similar to the 1928-1968 period where the 10 Yr U.S. rate bounced between 1.95% and 5.53%?
4. Similarly, what if inflation numbers remains tepid for an extended period of time? Again, I think the last 40 years of inflation and fixed-income rates is just one unique period in market history. It doesn’t mean we are automatically bound to head in the opposite direction now.
5. 10 Year U.S. Treasury Annual Returns from 1928 – 1971? 2.89% Nominal. 10 Year U.S. Treasury Annual Returns from 1972 – 2015? 7.07% Nominal. That’s massive. I think we sometimes forget just how unique of a time period the last 40 years were for Fixed Income investing. This has caused many people to expect both solid returns AND safety form their bonds. Moving forward, we may get back to just seeing safety…not a horrible thing, although potentially frustrating.
6. We have no idea what the nominal returns on stocks & bonds will be over the next 40 years. We will not know what the inflation will be either, but as history has showed us, they seem to typically go hand in hand (Higher inflation demands higher nominal returns and vice-versa) so…as long as you have a solid plan and stay the course over the long-term, I think (hope) that when the next 40 years go by, you (and me) will be just fine (You knew this part was coming).
Have some fun out there!