>When investors, wall street, and the media talk about the returns of different investments they are usually talking about “Nominal” returns. The term nominal refers to the actual return of an investment including the return generated solely by inflation (which really isn’t a return at all). What does this mean in plain english? The nominal return is the return you see, but not the return you get to spend. Most investors have no idea that they should be focusing not on “nominal” but on “real” returns. A “real” return is simply the rate of return you earn on an investment after subtracting inflation. Let me give you an example.
Let’s say you that on January 1, 2005 you put $1,000 into an investment with the intent of selling that investment in one year (January 1st, 2006). Your intent is to purchase an item that on January 1st, 2005 cost $1,000. During the year you earn a total return (nominal) of 6% and end up with $1,060 (ignore taxes for now). If the item you planned on purchasing with this money will now cost you $1,070 have you actually earned anything with your money? The answer is no. Even though your money earned 6% during the year, the prices of the items you want (and presumably need) to purchase rose by 7% during that same time period. Your investment return didn’t keep up with inflation. Even though 6% seems like a good rate of return, in reality your “real” rate of return (Return after inflation) was -1%. You actually lost purchasing power, your actual return, the return you can spend was negative.
As an investor your pursuits should focus not on the returns that you can see, but the returns that you can spend. Over the long run you want to invest with the goal of earning a “real” return. You want your money to grow faster than that of inflation so that your money can buy at least the same or more than when you started to invest it.
You often hear in the press that stocks have historically earned about 10%, however that shouldn’t mean anything to you. What you should really be asking is what did stocks (or bonds) return after inflation is taken out, what is my “real” return. Long term the “real” return of stocks has been about 6.5%. The next question that must be posed is whether or not going forward we can expect to continue to earn 6.5% above inflation from holding stocks. My instinct is that it is a possibility, but unlikely. My next column will focus on what return we should expect in the years ahead from different asset classes.
Until next time……….
>Yesterday a client of mine called and told me her son was purchasing a home in Arizona. 4 bedrooms, 2000 sq. ft with a front and backyard, basically brand new. The price of the home…….$200,0000 (up from the $170’s just last year). The same type of home where I live, sunny Southern California (Orange County) would go for at least $600,000 and have nearly $10,000 in real estate taxes annually to boot. That is a pretty big difference. With no money down you are looking at a payment with taxes of $4,334 per month in Orange County (assuming 30 year fixed), but only $1,218 in Arizona. Orange County is 3.6 times higher priced on a monthly basis. The question becomes “is living in Orange County (or many other expensive areas) 3.6 times better than in Arizona?” The answer is that I don’t know. Perhaps Orange County isn’t overpriced, Arizona is just underpriced.
What I do know is that from an investment standpoint the Orange County home doesn’t look like a very good deal. If you were to put 20% down (mortgage of $480,000) your payment with real estate taxes would be about $3,558 monthly, yet you would be lucky to get $2,400 in rent per month (I currently pay about $1,900 for such a home in rent). Even on an after-tax standpoint you aren’t breaking even cash flow wise, once you add in the cost of housing maintenance and vacancies (another $200 monthly minimum) you don’t have an investment, you have a speculation. You are speculating that either the price of housing will continue to rise, or that rents will rise quickly enough to make your cash flow work. Now, the Arizona property probably won’t cash flow either, but the difference is much less and long term the risk is much less – you don’t require that prices go up considerably to make money.
In my opinion residential real estate prices are too high in many, but not all areas. There are many factors involved in this that would take too long to explain here (see my links below). My advice is to be very aware of the risks that you are taking when purchasing a home in these expensive areas, don’t fall into the mindset of “Real estate can’t go down” or that “this time its different.” I am not saying don’t buy real estate, I am saying be sure it makes sense for you and that you understand all the risks going in.
What follows are some links to recent articles in Money magazine that I think you will find interesting.
The Schiller Interview
Irrational Exuberance – Again
Bang for the Real Esate Buck
Until next time………..
>2004 has come to an end and it turns out that it was a banner year for a diversified portfolio. Even the S & P 500 managed to rise above the 10% mark, not bad considering all the pessimism that pervaded the markets during 2004. Interestingly enough, the vast majority of the returns earned in 2004 came after the election.
Through September of 2004 the S & P 500 was up a meager 1.41%, however a globally diversified portfolio of stock mutual funds was up between 5 – 7.5%. Once the election was over the markets took off, let by small, international, & value stocks. A globally diversified all stock portfolio ended up with a return between 19 -22% where a more balanced portfolio holding 60% globally diversified stock and 40% fixed income returned in the 11-14% range. It is interesting to note that a globally diversified 60/40 portfolio beat the S & P 500 index for the year with less fluctuation. While this is great, don’t expect it to happen every year. The same portfolio vastly underperformed the S & P 500 during the go-go years of 95-99 and on a total return basis since 1995. Diversification is the smart way to go, but the price you will pay is that sometimes you won’t perfectly track the market – THIS IS OK.
I’ll be chiming in with more observations about 2005 soon, keep checking back!