In speaking with my financial advisory clients, I find the most misunderstood concept is the difference between nominal returns and real returns. And Wall Street brokers and bankers are very quick to take advantage of this situation.
Simply stated, a nominal return is the annual percentage return a security or asset earns each year in total. It is the annual return you see stated in the newspapers or online for any particular asset. The real return from holding that asset or security is this nominal return less the current inflation rate. People speak of what an asset's "real" return is after adjusting for inflation.
Let's look at an example. The stock market might appreciate 7% next year, but if inflation next year is 4%, then your real return is only 3%. Because general inflation in this example is 4%, everything that you might want to purchase is going to cost 4% more, on average across all goods and services, so the cost of living increased 4% during this year. You must earn at least 4% on your investments in this hypothetical example just to keep up with inflation and to preserve your purchasing power. Preserving your purchasing power means that you can buy the same amount of stuff at the end of the year as you could at the beginning of the year.
But what if a Wall Street broker is selling you a bond with a fixed coupon of 3% per year. If next year, inflation goes to 4% then your real return on holding that bond for the year is -1% which is the nominal return of 3% minus the inflation rate of 4%. Yes, you will see a fixed return of 3% for the year, but because it did not keep up with inflation you did not preserve your purchasing power and so you would be 1% poorer or worse off.
So, Wall Street can make lots of money during periods of moderate to high inflation. Your portfolio may increase in stated nominal value by 5% to 10%, but if inflation wipes out those returns than your purchasing power hasn't increased at all and yet Wall Street still extracts its fees and expenses. Your real returns are zero or negative, you are actually getting poorer each year, and yet your advisor on Wall Street is clearly getting richer. This takes the concept of "pay for performance" and turns it upside down.
This is exactly what happened in the 1970s in the United States when people's investment portfolios were growing in value at 10% per year but inflation was growing at 15% per year. People were losing 5% of their wealth or purchasing power each year, and yet they didn't seem to mind paying their broker 1 to 2% per year in fees for this privilege.
I bring up the 1970s because I think that is what the next decade facing us today is going to look like. I expect inflation in the United States to reignite and it would not be surprising to see an average annual inflation rate over the next 15 to 20 years of some 7 to 12% per year.
Why? Because general inflation occurs in a country when a central bank like the Fed decides to print money to either help bailout it's struggling banks or to fund its government's annual operating deficits. This has been going on for quite some time in the United States. It should shock you to learn that there is 50 times more currency and reserves outstanding in the US today than just 50 years ago in 1962. Think of that. In essence, the amount of currency in circulation has increased 50 fold in 50 years. This means that the amount of dollars in circulation in the United States has doubled, on average, almost every eight years for the last 50 years.
And recently, Ben Bernanke is accelerating the process. He has seen fit to triple the amount of US dollar currency and reserves outstanding just in the last five years. Given that the country is facing trillion dollar plus deficits with no appetite from Congress to either cut spending dramatically or increase taxes it is only logical to assume that this counterfeiting will continue. And that's just what it is, counterfeiting. What else do you call it when an entity like our government prints new paper currency in the basement of the Federal Reserve to pay for goods and services that are consumed by the government? And the trillion dollar deficits will only get worse as Social Security and Medicare become more cash flow negative in the future.
And now the government's hands are pretty well tied. Because our country's total debts of $16 trillion exceed its total annual GDP it will be difficult for the US to continue to borrow more in the future to fund its deficits. I don't see the United States defaulting on its debts so the only way out is to print more currency. It would not surprise me if the Fed printed 3 to 5 times more currency over the next 10 to 15 years meaning that we can expect inflation to explode and prices to increase some 200 to 400% over this time period.
Just like in the 1970s, we could be looking at inflation rates and interest rates of 10 to 15% per year or greater. And Wall Street will love this. They will be able to justify their exorbitant fees of 1 to 2% of your total portfolios assets each year by reporting that your portfolio had grown in value by some 8 to 10% per year and with the unsuspecting investor not realizing that because inflation was actually in the 10 to 15% range he had lost wealth or purchasing power every year.
This is the world we are heading into. Wall Street will continue to extract 1 to 2% of your wealth each year for fairly worthless investment advice but will tell you your nominal yields are positive and growing so if you don't adjust for inflation you'll think you're better off when you're actually losing money and purchasing power.
And it doesn't take very long to lose everything if you're paying a broker 1 to 2% a year to do nothing. You can lose half of your wealth and purchasing power in 20 years if your broker is taking 2% a year in fees and after inflation you are not generating any real return.
And please don't take comfort in the fact that many brokers tell their clients that their accounts are no-load in nature and have no fees and expenses attached to them. This is another way Wall Street rips off small investors, by lying about all the hidden fees and expenses that they charge. We will examine how they hide their fees and expenses in a future release from the Ethical Investor.
20 Ways Wall Street is Ripping Off Small Investors
- Providing nominal returns, not real returns.
- Encouraging too much diversification, if that's possible.
- Hiding fees and expenses.
- Turning you into a passive investor.
- Convincing you that money markets are the same as cash.
- Telling you that bonds are safer than equities.
- Explaining that in the long run equities outperform bonds.
- Simply by lying about their products.
- Convincing you that their bank is a large, stable, safe operation to deal with.
- Recommending products that have enormous sales commissions attached to them.
- Cheating you on bid/ask spreads.
- Selling you what they don't want.
- Measuring your success in dollars.
- Lending your securities to others.
- Ripping your eyes out if you ever try to close your account.
- Grabbing any slight positive real return for themselves.
- Sticking toxic waste to small investors.
- Pretending they can pick stocks.
- Acting like they are your best friend and they have your best interests at heart.
- Knowing next to nothing about the value of holding real assets like gold and real estate.
John R. Talbott is a best selling author and financial consultant to families whose books predicted the housing crash, the banking crisis and the global economic collapse. You can read more about his books, the accuracy of his predictions and his financial consulting activities at www.stopthelying.com
Content concerning financial matters, trading or investments is for informational purposes only and should not be relied upon in making financial, trading or investment decisions.