Lost in the debate over Social Security’s supposedly imminent demise is the coming battle for real returns. As the old and young generations battle at the ballot box over their respective shares of the nation’s wealth and income, market forces will be quietly at work seeking their own solution.
As more of our population leaves the workforce, we end up with fewer workers providing goods and services to more retirees. Retirees will be cashing in their portfolios from IRAs, trusts, pensions and other savings mechanisms in order to buy things they need. More things, produced by fewer people, means that each worker is asked to produce more than he or she did before. Something has to give to maintain balance.
That something can take one of two forms. Either the workers demand to be paid more for producing more stuff per person, or the retirees stop trying to buy so much stuff. If workers get paid more, the cost of the goods goes up and inflation will likely ensue. However, the Federal Reserve has something to say about inflation, and can instead cause the second thing to happen.
That second thing is an interest rate increase, a contraction of the money supply and the potentially fierce erosion of the value of portfolios of stocks and bonds. This erosion will stop the older folks from trying to buy so much stuff.
On the one hand, we have inflation. On the other hand, we have lousy stock and bond returns.
We cannot predict with any certainty which effect will win out, but we really don’t have to. Both effects add up to the same result: Low real returns.
Real returns are those left after inflation. When is a 5 percent return better than a 10 percent return? If your stocks go up by 10 percent at a time that inflation is running at 8 percent, you made a real return of 2 percent. If you earn 5 percent in your portfolio while inflation is only 2 percent, you made a real return of 3 percent.
Since all we care about is real return, the lower total return is better.
In the case of our pending generational shift, either inflation is high, or portfolio returns are low. Either way, the real return will be compressed. We needn’t even wait until the generation shift is in full swing. Virtually every major asset class is today priced to provide a low real rate of return.
Investors need to form a strategy for investing their portfolios that anticipates both an inflationary environment and a bear-market environment. Instead of focusing on gross return, we should focus our attention on ensuring that we capture a stable and safe real return. Again, it does little good to earn 10 percent if inflation is 8 percent. But earning 5 percent when inflation is zero is a wonderful result.
Real return investments are those that are most likely to have their returns increase in near-lockstep with inflation. Certain types of commodity investments, inflation-indexed government bonds, energy stocks and partnerships, dividend-paying stocks from industries with low economic volatility, these are the sorts of investments that have a higher probability of maintaining a positive real return across the business cycle.
A common mistake is to consider income property in this category, since rents will rise with inflation. The problem is that they don’t increase enough, and many investors make a simple math error. If your property’s income yield is 10 percent, and inflation rises by 2 percent, you now need 12 percent to maintain your real yield. But, if rents rise by that 2 percent inflation amount, your income yield only goes up to 10.2 percent. In order to keep up with a 2 percent jump in the inflation rate, you need your rents to rise by 20 percent, and that is quite unlikely to happen.
Faced with uncertainty, the winning investment strategy will seek consistent real returns so that they will watch their portfolios grow in purchasing power.
Rick Ashburn manages investments for private clients. Write to him at firstname.lastname@example.org or 7777 Fay Ave., Suite 230, La Jolla, 92037.