The Myth of the 7% Rate of Return
The commonly held myth of the middle class that an investment should return about 7% per year on average. This is the conventional wisdom, and largely based on the fact that the american stock market has averaged out to this number over a long period1. The idea of a 7% rate of return can also become a self fulfilling prophecy using mechanism that cause any other rate of return to adjust itself to 7%.
Price Adjusts to Maintain 7% in a Liquid Market
Let's say that I own "Widget Derivative Partners" (WDP), and we are doing great. WDP totally legitimately makes a 25% return every year for a while, because of our fabulous efficiency. To keep the example simple, WDP pays 100% of this out as a dividend, and it's stock starts our example trading at $100 per share. Because it's return is great the value of a share of WDP stock goes up. Any investor currently getting 7% returns says "Hey, that's a great place to put my money" I'll pay more than $100 a share for WDP stock, I'll pay $200 a share!"
At $200 a share it's still a great buy, and returns almost 14% on the dollar, so the next investor comes along and is willing to pay even more for a share, and so on, until they get to around $357 per share, at which point WDP is returning almost exactly 7%.
Because conventional wisdom is that 7% is a fair rate of return on a liquid asset, 7% is what that rate of return becomes. It's important to note that the 7% is arbitrary. If the commonly held myth were that the rate of return should be 3%, then this process would continue until WDP was returning 3% at a price of $833.
Exposure to risk to Maintain 7% returns
A second mechanism that drives the rate of return to the expected 7% is the use of exposure to risk. Let's say that I'm the CEO of "Long Widget Investments" (LWI). LWI is struggling and returns about 4% a year (again, all in dividends, in order to keep the example simple) on it's initial $100 price. The expected market reaction is for the stock owners to say "Hey, I can do better! I'll sell for as cheap as $57 in order to bring things back to a 7% return", essentially the reverse of the above process. They also will likely lean on me, the CEO, to raise the rate of returns quickly.
As a CEO, if I keep having a 4% return and/or the company looses ~40% of it's trading value under my watch, my career is not going to be in good shape. But I have another option... I can take on greater risk in order to raise my returns. Specifically not the sort of risk where one gambles a little in the hopes of making a lot (Such as roulette, or a new marketing campaign), but the sort of risk where one gambles a lot to gain a little, with a very high likelyhood of success (Similar to "picking up quarters in front of a moving steamroller")
For instance maybe I cut back the annual maintenance budget for the widget factories. Maintenance is very expensive, and usually everything is fine without it. If something breaks, then we loose a lot of high cost capital equipment, and suffer a lot of downtime, probably putting us into the red for the year. 4% returns was already catastrophic failure for me as CEO though, so 0% isn't really much worse.
By cutting corners, I take on more and more risk in order to bring my numbers back to 7%. There are plenty of formal processes that will attempt to asses the risk-factor of actions like this, report them with claims of accuracy, and factor them into prices. The reality is that this sort of messy, interaction-with-the-real-world growth risk is nearly impossible to quantify, though any attempt is better than ignoring it. It is also possible that having some firms catastrophically fail occasionally is good for the system as a whole.
Credit can also be used to maintain 7% returns
A slightly less creative CEO, can just ram LWI's numbers (and risk) up by taking on debt. The following example is extreme, and kind of absurd, but it should be noted that the numbers actually work out just fine. It's big and dramatic to make it clear what's happening.
Let's say LWI has 300 shares on the market, and they are trading at $100 a share. That means LWI generates a pretty reliable $1,200 a year, giving it a 4% return. I, as CEO, Borrow $15,000 at 1% interest 2
Now LWI generates $1,200 - $150 in interest on my loan or $1050 / year.
I take that $15,000 and have a stock buy-back of 150 of the 300 shares... so 150 remaining shares generating $1050/year, or $1050/150 = $7
now LWI at $100 suddenly returns 7%!
The thing is, after the stock buyback, LWI is now a much riskier company. For one thing the volatility is nearly double. If LWI sees an extra $50 in income, or $50 less in income, that has almost double the effect on the bottom line, and that 7% return rate. The market will react as explained in the "liquid market" section we started with. More critically, LWI is now totally exposed to fluctuations in the interest rate. If interest rates go from 1% to 2%, suddenly LWI's rate of return changes to ($1200 - $300)/150 = 6% ... and following the logic of the "simple liquid market" you would see share prices fall from $100 to $85.
If you have ever wondered why people get so worked up about the Federal Reserve moving interest rates up or down by 0.25%, this is why. These examples are all pretty much real, though simplified, and with much smaller numbers. LWI and WDP can be thought of as Banks of America and Goldman Sachs, and you can append the word billions to end of each number.
2% Inflation + 3% economic growth = 7% expected return?
Perhaps the greatest mystery is why we all expect that rate of return to remain 7% indefinitely. When people call it an average, they mean since 1950. The problem is that average inflation over that period has been near 4%, as opposed to the 2% we have had for the last two decades. 4% inflation + 3% economic growth does, in fact, get you about a 7% rate of return, and it does it without massive dysfunctional shenanigans.
For the last two decades, however, we have somehow tried to pull off the magical equation 2% inflation + 3% economic growth = 7% expected return. It seems like that extra 2% is coming from two places. One is a massive bubble of credit and risky corner cutting that has been building up since 2008. The second, I would guess, has been the stock market and other financial instruments & assets sucking up real wealth from the general populous. This can be seen in the ever-rising levels of consumer debt. Ultimately, neither of those is real growth, and so we would expect them both to come catastrophically due at some point in the form of another financial crisis, even without the bubble dynamics I'll talk about in a later post.
- 1. This is also something that Warren Buffet famously said, and some people accept that as an argument from authority
- 2. If 1% sounds crazy keep in mind the Fed was lending below that rate from 2008-2017. Most corporations would have trouble getting to that money without middle men taking their cut, but I'm also simplifying out a bunch of other stuff like smaller float sizes for reasons of clarity