What your long-term investment will earn you fits in four words: compounded, real, net, return.

The compounded real net return

Your long-term gain, the compounded real net return has as many components as words (for those not following, that means four):

The nominal gross return can be controlled (to an extent) by asset allocation: with more stocks for example, it will be higher on average. Fees can (should) be kept low. Inflation and compounding of returns on the other hand, you will point out, are not something you can change. This is true, but what is important is to take them into account. A nominal yield of 9% seems three times as high as a 3% yield. But with inflation at (say) 2.5%, real returns stand at 6.5% and 0.5% — a thirteen-fold factor. And compounded over twenty-five years, that's a gain of 380% instead of just over 13%, making it almost thirty times as much!

If you do not grasp the critical importance of inflation and compounding you will say that, of the two investments above, one is worth three times as much as the other, and you'll wonder if it justifies drawbacks such as those scary stock market crashes. But if you do grasp the point, you'll have a very hard time finding a reason not to choose to make thirty times more.

A little comparison

The table below gives an idea of the difference between investments in stocks and bonds, and between well-controlled and uncontrolled costs. The difference between stocks and bonds is the basic investment performance (the first row of the table): the average return on an investment in shares is significantly higher than that of bonds. The difference between the two stock funds is fees (row two). Net returns are clearly different (8.8% against 6.5% against 3.8%), but when you factor in inflation and compounding over twenty years, you see a factor of two for the impact of fees and a factor eight for the difference between stocks and bonds (and even bigger differences over thirty years).

gross nominal return 9   % 9   %  4 %
− fund fees − 0.2% − 2.5% − 0.2%
= net nominal return = 8.8% = 6.5% = 3,8%
− inflation − 2.5% − 2.5% − 2.5%
= real net return 6.3% 4   % 1.3%
gain over twenty years $240 000 $120 000 $30 000
gain over thirty years $525 000 $225 000 $47 000

Table: Possible returns for a passive stock fund, an active stock fund and a bond fund. Percentages are annual, and purchasing power gains are for an initial capital of $100 000. (Taxes and entry/exit fees not included.)

Inflation and compounding do not change the ranking of the investments, they only dramatically increase the scale of the differences. The investment that pays the most is the one with the highest return net of costs. If this net return is much higher than inflation then you get the full benefits of compounding in the long run.

This is obviously not your only selection criterion, especially for shorter durations. And perhaps in the end you will choose an investment that will return on average only five times more than bonds over twenty years (e.g. to reduce psychological consequences of volatility). But even in this case the four words that control what you're going to make are: compounded, real, net, return.

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