Where do Investment Returns Come From? (Hint: it's probably not where you think)

If you were to tune into a business news network or even go to a website that has the latest stock market stories for the day, you would probably be inundated with stories about what the President said, or where analysts think interest rates are going, or what hot new product is coming to market at a given time. In fact if I look on today's date (November 13, 2019) I see a story about US-China trade talks, a story about the new Disney streaming service Disney+, and also a story about Jerome Powell's speech earlier today about the future of interest rate movements by the Federal Reserve.  We hit the trifecta!

These stories have all affected the market prices of securities on the day today.  

Chinese stocks were down on the day. Disney Stock was up. US Bond Yields were down. So it seems like these stories matter a lot for your investment returns. And in the short term, they do matter a lot. They can also be very unpredictable. Fortunately for us, we don't often spend much time thinking about our investment returns in the short term. We spend a lot more time thinking about investment returns in the long term.  And in the long term, there are entirely different factors that matter.

We actually have data for common stock returns going back a very long time in the US. Over 200 years in fact. The fact that we have such a long period of data allows us to really take a look at what drives returns in an investment over the long term. Over the period from 1802 to 1999, US stocks averaged a real rate of return of approximately 7% (Source: Chapter 2 of Common Sense on Mutual Funds By Jack Bogle).  

The Power of Compound Interest

For those of you who don't believe in the power of compound interest, consider this. If you invested $10,000 in US Stocks at the beginning of the period and held it to the end of the period, the $10,000 would have grown into $5.6 Billion in inflation adjusted dollars. Compound interest does work! During that period of time there was:

A War with Great Britain

The invention of the Railway and the completion of the Transcontinental Railroad

An incredibly divisive Civil War and the emancipation of slaves

The invention of the automobile and the airplane

Numerous Banking Crises culminating in the creation of the Federal Reserve System in 1912

The First World War

The Great Depression

The Second World War

The invention of the computer

The Korean War

The Cuban Missile Crisis

The Civil Rights Movement

The collapse of the Bretton Woods system of international exchange and subsequent price inflation and oil embargoes

The Vietnam War and War Protests

The start and end of the Cold War

The invention of the Internet

The First Gulf War

The Tech Bubble

The assassination of four presidents (Abraam Lincoln (1865), James A. Garfield (1881), William McKinley (1901), and John F. Kennedy (1963)

The impeachment of two Presidents (Andrew Johnson and Bill Clinton) and the resignation of a third under duress (Richard Nixon)

And that is really just scratching the surface of the various events that would have shaped the short term returns of common stocks over that time period. Nevertheless the results at the end prove that these various crises and events had little impact on the long term returns. So if short term stories don't matter for long term returns, what does matter? The question that goes hand in hand with what matters for returns is "where do our returns actually come from?"

Effects on Returns

We can use the historical data to show that the reason stocks have grown at 7% annually is almost entirely due to the rising earnings and dividends of US corporations during that time. The long term real return on stocks derived from dividend yields and earnings growth, adjusted for inflation is approximately 6.7%. It is virtually identical to the long term real return of common stocks. All the other factors have almost a miniscule effect on the returns provided. There were definitely fluctuations in returns over different periods of time but the long term average always regressed to these two fundamental factors.

Fluctuations in the Price to Earnings Ratio is the Main Cause of the Deviation

The main cause of the deviation has to do with fluctuations in the price to earnings ratio. At certain points in time, investors have been willing to pay more for each dollar of earnings than at other points in time.  This speculative behaviour explains the deviations from the fundamental returns of dividend yield and earnings growth above, but it doesn't change the long term returns. So what do we do with this information? It's simple. Since we know our long term returns are driven by the fundamental quality of the businesses we own, we should devote all of our attention to trying to identify the highest quality businesses which will provide the best combination of dividends and earnings growth.

On the other side of things, we should largely ignore the short term stories that we see and read about in business news which influence the short term prices of the businesses we own. Investing can be a simple exercise if you want it to be, and if you focus on the two simple fundamentals of dividends and earnings growth, you are well on your way to a positive investment.

- Craig White, BA, LL.B., CIM

Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.