Article / 20 January 2016 at 12:00 GMT

Real rates of total return flying high

  • Real, not nominal rates, matter in investment terms
  • Real rates for deposits and cash tended to be less 1% over the past 24 years
  • Stock yields have fluctuated heavily and on average are higher than cash rates
  • In 24 years, the accumulated difference in return is 507%, after 25 years even 550%
  • Compound interest plays an important role
snowy valley
River deep and mountain high ... real yields on
savings and investments differ a lot. Photo: iStock.
 
By Clemens Bomsdorf

In the article published a week ago, I looked at the real rates of return for cash and deposits. Investigating these over time, we have learned that real annual yields have been negative before, but saw comparatively little fluctuation over the last 24 years, according to a recent study by Germany’s central bank (now also available in English here). 

Before (in an upcoming article) looking at how real rates of return influence investment behaviour, let’s turn to an asset class with a very different pattern, the share market.

Share prices are very volatile ... 

The valuation and hence rate of return of shares (which is the relative increase in share-price value plus dividends and, in case of real rates inflation is taken into account as well) varies very much over time. In the long run, differences tend to be smaller though still clearly exist. 

The low nominal (and real) interest rates have meant that many private and professional investors in recent years have increasingly turned towards stocks. Quantitative easing pushed money further into that direction. It's not only worth seeing how shares performed in recent years, but how they have developed over the longer run – adding real rates of return data.

xxx

It doesn't take weird glasses to see the difference
between yields, 
but clear calculations. Photo: iStock

Again we focus on Germany since the in-depth report by the Bundesbank is our main source. However, the number on real rates of return for shares held by German households is in line with other Eurozone members. 

... but on average that comes with a higher total rate of return

It does not come as a surprise the Bundesbank states that: "...[i]n contrast to bank deposits and insurance claims, the return on shares held by households exhibited very strong volatility indeed over the period under review. Extended periods marked by high returns, such as during the New Economy boom and in the run-up to the financial crisis, gave way to slumps that were nearly as pronounced."

Let's have a closer look at this chart, the lower part of which was presented already in the last article.
Bundesbank rates of return over time

One can clearly see the volatility of stock prices. The surprise comes in how high the average real annual return rate was: "... that being said, shares came in with a real annual return of just over 8% on average between 1991 and the end of the period under review, making them the highest yielding asset type in the portfolio. The same can be said for the last few years, their lacklustre performance of late notwithstanding.“ 

Safe bets might be costly in the longer run

So while the real rate of return for currency and deposits was almost non-existent, the same cannot be said for shares. A small reminder: As said in the previous article, the Bundesbank stated: "From the 1990s onwards, it was usually less than 1% and even dipped into negative territory on occasion, though never to such a great extent or as persistently as in the current setting of low nominal interest rates."
different rates of return
Source: own calculations

This extreme difference is the main finding of today's article. Take into consideration what a difference of seven percentage points means for compound interest (click here). An investment of EUR100 over 24 years can become EUR127 in real terms if the money is invested in cash (at a real interest rate of 1%) or EUR634 (at a rate of 8%) if invested in shares.

Since 24 years is kind of an awkward period since people rather think and calculate in 5 years steps, below the same calculation is made for 25 years.

25 years
Source: own calculations 

However, saving means putting aside money on a monthly or annual basis and does not include just the initial deposit. However, that does not change the general effect of compound interest, nor the end result. Also, since volatility is much higher when it comes to stocks, the blue line is correct in showing the 8% average real rate – but it does not depict the share-price movements (volatility). 

This finding might precipitate private investors to buy more stocks and what the different real rates of return really mean for investment behaviour will be discussed in another article. Also one text will come with further data on real long-term stock market performance. After all, the last 24 years investigated by the Bundesbank could quite easily have been an extraordinary period. 

Bundesbank
This article would not be complete without another of these beautiful photographs of the 
Bundesbank HQ, again a BOL - German for "Pictures without People" (They are probably all 
inside making calculations.) Photo: Bundesbank

To conclude let's briefly look into how the stock performance calculation was made by Bundesbank. 

The report's aim is to investigate how household savings and investments really did develop – that does not only mean taking into account inflation, but also looking at the asset mix of households.

When it comes to stocks, the rate of return is not mirroring how one particular index performed, but how a basket of several indices and stocks did, weighted according to an average household’s investment. If interested in more details about the calculation, read this box. It is not based on any one index.

Bundesbank Stock performance calculation
Source: Deutsche Bundesbank 

– Edited by Adam Courtenay

Clemens Bomsdorf is a journalist and consulting editor at TradingFloor.com

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