If you invest money, perhaps because you want to give money in the future, you want a good estimate of the real rate of return so you can compare it to just giving now. Small differences in this estimate have very large effects over decades, and just today I've seen people giving numbers as far apart as 2% and 8%, which over 40 years mean 2.2x growth and 22x growth respectively.
What is reasonable here? If you look around online at personal finance sites you'll see numbers like 6%, 7%, 10%, 11%, and even 12%. First off, these all ignore inflation, which has averaged about 3%. Naively subtracting, this gives us real rates of 3%, 4%, 7%, and 9%. There's also a lot of cherry-picking: if you're willing to choose specific years and specific indexes you can get quite good numbers.
There's an even bigger cherry-picking problem, however, in that they're all based on US returns. Other countries have had worse economic performance, or have even had their stock markets wiped out. Dimson, Marsh, and Staunton (2013) (pdf) (summary) conclude that investors should expect much lower returns:
We have estimated that over the next 20-30 years, global investors, paying low levels of witholding tax and management fees, can expect to earn an annualized real return of no more than 3.5% on an all-equity fund and 2% on a fund split equally between equities and government bonds.
The difference between 7% interest and 3.5% interest is the difference between 60x and 8x over 60 years. This is really important if you're trying to decide whether you do better to save money now and donate later after several decades of compound interest. [1]
Surely if a certain future payoff is expected a priori to be good (because of expected favorable business climate or whatever), then the price paid will adjust accordingly. This means that expected return (a function of price paid and payoff) will be comparable to other investments with similar payoffs, rather than being good.
If, say, business climate were unfavorable, and payoff is expected to be low, price paid for the investment should adjust for this so that expected return need not be low.
If there is large degree of uncertainty associated with a payoff, then expected return may be high to reflect the low price one might get due to people's distaste for variance. (The expected return may be low though if people have a taste for variance; e.g. lottery tickets.)
The point is that expected good economic conditions per se need not be the driver of a priori expected returns. (That they are expected means that the price adjusts to reflect this, leading to mediocre returns.) Rather, the higher order moments of the (subjective) payoff probability distribution may play a more important role.
If you invest money, perhaps because you want to give money in the future, you want a good estimate of the real rate of return so you can compare it to just giving now. Small differences in this estimate have very large effects over decades, and just today I've seen people giving numbers as far apart as 2% and 8%, which over 40 years mean 2.2x growth and 22x growth respectively.
What is reasonable here? If you look around online at personal finance sites you'll see numbers like 6%, 7%, 10%, 11%, and even 12%. First off, these all ignore inflation, which has averaged about 3%. Naively subtracting, this gives us real rates of 3%, 4%, 7%, and 9%. There's also a lot of cherry-picking: if you're willing to choose specific years and specific indexes you can get quite good numbers.
There's an even bigger cherry-picking problem, however, in that they're all based on US returns. Other countries have had worse economic performance, or have even had their stock markets wiped out. Dimson, Marsh, and Staunton (2013) (pdf) (summary) conclude that investors should expect much lower returns:
The difference between 7% interest and 3.5% interest is the difference between 60x and 8x over 60 years. This is really important if you're trying to decide whether you do better to save money now and donate later after several decades of compound interest. [1]
[1] If you're saving for your own retirement tax incentives are probably more important than interest rates.
Cross-posted from my blog