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Ask an economist to define the real rate of return on common stock and chances are he will say the percentage gained or lost after adjusting earnings for inflation. The rates of return on common stock and other investment products calculated by accounting solely for inflation are temporary earnings. The judicious investor knows beyond the cutting reality of inflation lies brokerage fees and management expenses, which eat into earnings, lowering the real rate of return retained. Furthermore, at the end of the tax year, income zipped off to Uncle Sam's coffers in the form of capital gains taxes and taxes on dividends negate additional gains.
Due to the unpredictability of short-term views of the stock market, analyzing one-year returns on common stock provides little in the way of beneficial insight to the average investor. Volatility in the markets at its most extreme can be easily understood by looking at the inflation-adjusted real rate of return for 1862 -- a whopping 66.6 percent -- and comparing that with the real return in 1931, a devastatingly dismal -38.6 percent. Based on isolated 12-month periods, the rate of return varies from -12 percent to a positive 24 percent, according to Jeremy J. Siegel, finance professor at University of Pennsylvania’s Wharton School.
In an August 2011 publication, Thornburg Investment Management, based in Santa Fe, New Mexico, cites returns based on the S&P 500 Index from the end of 1980 to the end of 2010. A $100 investment on December 31, 1980 returned a nominal 10.71 percent through the end of 2010. Real return, at 5.23 percent, after subtracting taxes, expenses and inflation, is less than half the nominal rate. Looked at in actual dollars gained makes the disparity evident. The original $100 invested grows to $2,119 using only nominal return. However, once allowances are made for trading and management expenses, inflation adjustment and taxes, the real return becomes $462.
Small-Caps and International Stocks
The figures quoted above use earnings solely from the large-cap stocks indexed by the S&P 500. Small-cap stocks in the Russell 2000 earned a real return of 4.97 percent over the same 30 years. Nominal return for Russell 2000 small-caps was 10.04 percent. Nominal return on international stocks that mirror the MSCI EAFE Index was 9.70 percent with a real return of 4.54 percent.
Held for the long term, stocks earn more wealth for investors than bonds, money market instruments or real estate. When the past two centuries became the time frame for analysis, the annual inflation-adjusted real rate of return on common stock averaged more than 6.5 percent. A small annual decline in the real rate of return during the first decade of the new century is what John C. Bogle, founder of The Vanguard Group, says is "doubtless a more reasonable expectation for the future."
- "Common Sense on Mutual Funds"; John C. Bogle, 2000
- "Investment Analysis and Portfolio Management"; Fifth Edition; Frank K. Reilly and Keith C. Brown; 1997
- Library of Economics and Liberty: The Concise Encyclopedia of Economics: Stock Market
- Thornburg Investments: A Study of Real Real Returns