How do I know if I am setting the bar too high or low with respect to my expectation on future returns?

First let’s address the question of the lower bar. What should be the bare minimum returns, I should generate over the long run.

In order to address this question, let’s take a step back and ask a fundamental question:

What is investing?

In simple terms, it is putting aside some money in the present in the hope of receiving more money in the future.

Today let’s assume I have INR 6 lakhs. I have the option of buying a car right now. But however I decide to postpone my purchase and instead save and invest the money in an F.D which offers me 8% return so that I can increase my money and buy a better car. Fast forward 5 years, I have INR 8.8 lakhs and I am extremely happy as I have more money now. So as per our understanding of investing, we had put aside INR 6 lakhs five years back and received more money i.e INR 8.8 lakhs. Now I decide to buy a better car as I have more money. But I receive a shock when I go to the car showroom. The cost of the same car which I had wanted to buy 5 years back, now costs 9.6 lakhs !!

Though my investment had increased by 8% the cost of my car has increased by 10%. So while it feels like I have grown richer given the increase in money, the reality is that I have actually grown poor as the same car which I could have bought 5 years back cannot be bought now. Now why did this happen? The cost of my car increased at a higher rate than my returns.

This practical reality of higher costs is what a nerd calls “Inflation”. This means that our understanding of investing has to be tweaked to account for the “hidden thief” called inflation.

Let’s redefine investing from a practical point of view, as **forgoing consumption now, in or****der to have the ability to consume more at a later date **i.e Investing is not just about increasing money but the actual purchasing power.

Hence your investments should grow more than inflation to increase your purchasing power. So coming back to our question on what is the bare minimum return that one must strive to achieve – the returns must at least equal inflation if not more for preserving your purchasing power.

How do we know the inflation for the future. While I profess no prediction capabilities, as Keynes a famous economist puts it, the idea is to get it approximately right rather than precisely wrong.

Historically over the last 30 years India has had an inflation of around 7 to 8%. Hence its reasonable to expect future inflation to revolve around the same levels and therefore we set a cut off of a bare minimum at least 7.5% for your investments.

Let’s assume you have constructed an investment plan for generating a 15% return expectation. This means that your investments will be 4 times in 10 years while the costs would double (assuming 7.5% inflation). Hence an investment of 6 lakhs = purchasing power of 1 car will translate to approximately 24 lakhs while the car cost will be INR 12 lakhs. So after 10 years you will be able to buy 2 cars. Translate that into 20 years, you will afford 4 cars and 30 years you can afford 8 cars.

**This is how wealth is created – a combination of returns above inflation + adequate savings + long time period**

Now what if inflation comes lower let’s say to around 5%. This would imply that a 13% return is enough to replicate the same impact of a 15% return under 7.5% inflation scenario. Similarly if inflation becomes higher at 10%, then we need around 18% to replicate the same impact. So you can notice that there are three different returns 18%,15%,13% yielding the same result. The reason is the underlying not-so-obvious component – Inflation.

Thus the idea is that your return expectation instead of being fixated to a number should be relative to inflation. This is called real returns (actual or nominal returns – inflation). In the above case the real return is around 7.5% (15% actual return – 7.5% inflation). Hence when you set your target for an investment portfolio and are evaluating your returns focus on the real returns and not on the actual or nominal returns.

**Quick Takeaway:**

- Investing = increasing purchasing power and not just money
- Inflation is the not-so-obvious culprit which steals away your returns; Keep an eye on it
- In India, Inflation historically has been around 7-8% ( basically that means our costs go up 2 times every ten years)
- If your returns are below inflation, you are doing a bad job
- Focus on real returns i.e Actual returns – inflation

Now that we have a fair idea on compounding, inflation and real returns let’s move to our next question

How do we set reasonable return expectations for our investments?

Reblogged this on traderaja.

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