Where does investment returns come from?

As a business owner, I am in the privileged to ask some pretty interesting questions.

Chief of which is: “where the @#$%&! is this year’s increment going to come from?”
Year after year, employees without fail expect increment regardless of economic conditions.

But why should we expect it so? I am struck by how this expectation parallels the expectation of investment returns.

Year after year, investors without fail expect returns regardless of economic conditions.
Chief comments about investments sounds a bit like: ” Where the @#$$%&! is my investment returns? I put some money, I should get something back!”

So where does investments returns come from? What kind of returns is rational?

income vs capital

Income and Capital

Regardless of the type, all investments generate some form of Income, e.g. rentals or dividends, and Capital Appreciation, e.g. Property price increase or Stock price increase.

Ah, that is fine and well you say, but where does the income and capital appreciation come from?

To answer this question, we need to dig deeper.

inception

Digging deeper gives us a certain degree of certainty to our investments. We know the fundamentals and the factors which we can control and benchmark.

The answer to deeper question is: growth and inflation.

gowth inflation

When population grows, most companies grow to service the ever larger masses of people and thus generate growing earnings to give more dividends and capital appreciation. Growth is commonly measured by GDP:

malaysia-gdp-growth-annual.png

For inflation, there are many excuses for why it exists, my own version is that everyone gets greedy and tries to raise prices on each other, thus ensuring higher prices for everyone. Inflation is commonly measured by CPI:

malaysia-inflation-cpi.png

Now that we know where the returns are coming from, we can form some expectations about how much we expect to receive on average. Going by the historical records, we should expect about 5% from GDP and 2.5% from inflation.

So if 7.5% is the average, then the next question we should ask ourselves is: are we getting this result? And, how do we get this result?

If we are doing better than this benchmark, congratulations, but we need to ask ourselves what kind of risks are we taking that is generating the result out of the norm? Do we have sufficient protection in place for the extra risks taken?

If we are doing worse than the benchmark, too bad, but now we know to ask ourselves why did we do so poorly and what sort of opportunities did we fail to capture? Have we spent too much on protection and not enough on growth?

Remember we need to treat our investments like science, not gambling. If the economy is experiencing growth and inflation, we should be able to capture it using our investments. And, we should do it with enough diversification to capture the average result.

It is fortunate that there are investment instruments nowadays that can help to diversify and average out the result. Imagine if you are a business owner, depending on the specific nature of your business, you might not be able to generate the average result for your employees!

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