Wise Wealth Advisors

D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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Understanding real returns

Posted by Muthu on January 17, 2016

Anand Radhakrishnan, CIO- Equities, Franklin Templeton mutual fund said the following in a panel discussion:

“Secondly, Sir John Templeton said focus on post-tax real returns. In India we focus a lot on nominal returns. If RBI is indeed successful in its inflation objective of 4%+ or -2% and the world is anyway reeling under zero inflation or a deflationary circumstance, it is quite alright to have lower expectations on nominal returns. If the economy is growing at 5%, 6% or 7% and then inflation is at 4% or even less, return expectations are still pretty high when investors walk into equity funds.

Focus on real post-tax returns, which is I think is going to be very different over the next five years than it was in the last five. Not in terms of real returns, but in terms of nominal returns.”

We’ve seen how Sensex has delivered around 17% over last 3.5 decades and CRISIL AMFI equity fund index delivering around 22% in last 18 years.

As you are aware, our long term nominal growth has been around 15%. This includes a real growth rate of 7% and an inflation rate of 8%.

In the long run, let us assume we would grow at 8%. Let us also assume the inflation would settle down at 4%. If this is the case, the nominal growth rate would settle around 12%.

When the nominal growth rate of the economy falls, the nominal growth rate of equity also falls. So instead of 18%, we may need to tone down our expectations to 15%.

But real growth rate, which is what relevant to us, would remain the same or marginally inch up higher; as real growth component increases and inflation reduces in the nominal growth.

If you notice, MIPs over the long run have delivered around 2% more than fixed deposits. As FD rates fall, the nominal returns from MIPs also would fall. But it would still deliver around 2% more than FDs due to active debt management and equity kicker.

So nominal growth rate is not static. It depends on real GDP growth rate and inflation. We may need to adjust our expectations in line with nominal growth rate. But the real growth rate would remain the same.

Nominal growth need not only go down. It can go up as well. It is a function of what is the real GDP growth rate and inflation.

Learn to accept the following returns from asset classes over long run:

Fixed Deposits: Inflation + 1%

Gold: Inflation + 1.5%

Real Estate: Inflation + 3% to 5%

Equity: Inflation + 7% to 9%

Actively managed fund would deliver couple of percentages more than index.

So if inflation is 4%, markets may deliver around 13% and equity funds would deliver around 15%.

Likewise, for an inflation of 4%, FDs may deliver around 5% and MIPs around 7%.

Please note that none of the above is guaranteed returns but only used as an illustration to explain the relationship between inflation, nominal growth rate and various asset class returns.

So start focusing on real returns, this is what matters to you as an investor.

2 Responses to “Understanding real returns”

  1. rakesh ojha said

    this is exactly what i wrote in a “reply” a few days ago. you did not respond.

    there reasons why even real returns from the market in future will be low. nowhere near 18%. due to valuations. this is even more important. In 80’s valuations were nothing. now we are the darling of the world with valuations highest in the world. since even in a SIP we are buying at higher PE…future returns will be low (nominal or real).

    future returns are inversely related to buying valuations.

  2. rakesh ojha said

    Today sensex ended at level last seen on May 15, 2014 when Modi won election. Mutual funds saw inflows into mutual funds very single month since then totaling near $20 billion (matching FII withdrawals almost equally during this period) reversing earlier trend of outflows every single month for four years or so. They are all under water now. As usual, retail investors are last to join the party (in the likely fifth wave). EPFO started investing July last year. Again under water so far. If we see prolonged bear market which corrects five wave advance since 1979 (along with deflationary collapse in world markets), retail investors and EPFO could be in for major trouble. That could shake new found faith of retail investors and govt organization (EPFO) in equities.

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