Uncategorized

Where Do Returns Come From?

Today I was on a call with a new investor client. He was evaluating his own past investment decisions, which have landed him with nearly all of his money today in cash. I’ll save his full story for another day, but suffice to say, he was not happy with the results of more than two decades of trying various advisors and strategies. The only money he has now, he fears, is the money he put in himself.

This is sad. And this is the reason I do what I do.

Returns come from capital markets.

Capital markets are made up of companies that are seeking investors to share in the gains of their activities. These investors understand (or should) that they share in both gains and losses. On average, over many, many years, the gains from various capital market sectors have been very good. Capital markets pay investors for their money in the same way that banks do. If you give your money to a bank today, you will earn around 0.1% for your investment. For the bank, that 0.1% is a cost. Capital investment has a cost as well. Capital cost is measured over time and considers the ups and downs as part of the cost’s average.

  1. Small US companies for example, as measured by the Russell 2000 index, since 1973 (a very bad year BTW) have returned 12.70% annualized to investors.
  2. Large US companies, as measured by the S&P 500 index, since 1973 have returned 10.35% annualized to investors.
  3. Small International companies as measured by the MSCI Small index in the same time period have returned 12.89% annualized to investors.

In other words, these companies had to pay these returns to the “owners” of the company. If you own stock in the company, then you are one of its owners. The return you get, from the company’s perspective, is called the Cost of Capital. This is where returns come from – from markets – from all of these companies appreciating in value and sharing their profits with owners through dividends. Owning these capital markets in a passive way without selling them over long periods of time (think decades not years) has always produced positive returns after nominal fees for investors.

So what activities DON’T always produce positive returns?

  1. Owning single stocks. This can really pay off if you pick the right one(s). But you can also lose all of your money. How do you KNOW that the one you’ve chosen will do better than average, or will even last the next decade?
  2. Choosing mutual funds based purely on the past 5 or 10 year’s performance. This strategy has the possibility of giving you positive return but will almost always give you a smaller return than a low-cost index fund will. Actually, funds that have over-performed in the past are not likely to do even as well as the average market in the future.
  3. Buying and selling securities, currencies, or commodities daily. This will sometimes give you great returns and sometimes you will lose. This is also a very difficult method to track as far as total performance. The websites where most of this day trading is done are arranged very much like websites specializing in online gambling. The key here is to get you to place trades – how well you perform has no bearing on the success of the company you use.

We call these types of activities speculative. Is it possible to make money with them in the short run? Yes. And it’s possible to make money over a weekend at the casino.

But as a long-term strategy, any speculative activity is disastrous.