Portfolio Design: A Modern Approach to Asset Allocation

REAL RETURNS

Until this point, average returns have been measured without taking into account inflation. For a long-run investor, however, inflation can substantially reduce the real gain on a portfolio. Even modest inflation does a lot of damage. If inflation averages 2.5 percent per year, the cost of living rises by 28 percent in 10 years and by almost 64 percent in 20 years. Over time, moreover, inflation varies a great deal, so comparing nominal returns over different periods can be very misleading. In the 1970s, nominal stock returns (8.4 percent) were as high as in the 1960s (8.2 percent), but real returns were much lower in the 1970s (0.4 percent in the 1970s versus 5.1 percent in the 1960s).

To obtain real, or inflation-adjusted, returns, it’s important to use a compound formula. If π is the inflation rate, then the real return on asset j can be written as

Over the period from 1951 to 2009, the inflation rate has averaged 3.78 percent. So the real return on stocks and bonds is calculated as follows (using the geometric averages from Table 2.1).9

Inflation reduces bond returns proportionally much more than stock returns. A 2.2 percent real return on bonds seems small when earned by an asset with a 9.5 percent standard deviation.

The equity premium is seen in a new light once ...