Yield Curves and Breakeven Inflation

Real Yields = Nominal Yields - Breakeven Inflation

Equities carry the highest risk. Why, then, invest in equities?

You can also make a lot of money investing in equities.

During the long term, US stocks gave a historical compound annual return of 11% to its investors.  During the period January 1960 to December 2000, you could have earned a compound after tax return of 16.9% a year on your shares on the South African stock market.

Equities are one of the few asset classes that give you a real chance to fight inflation over the longer term.

The reason for this lies in the nature of equities.  Equities are investments that give you part-ownership in a company.

Companies issue shares because they need money (or capital) to expand. 

• When you buy shares, you own part of the company, including its assets. 
• That explains why, although the value of money decreases with inflation, your investment in a good company can increase as the company grows and the value of its assets increases. 

Note that we say a 'good' company. 

• Not all companies are good companies and not all share prices will increase over time, simply because not all companies will expand and grow. 
• That is why it is important to be clever when you make equity investments.

Besides your share in a company's capital (i.e. its assets less its liabilities), you can also share in its profits by way of dividend payments to the company's shareholders.  This is another reason why investment in equities provides one of the few opportunities to safeguard the REAL VALUE of your capital.  The term 'real' is very important in investment terminology.  It means that you have taken the impact of inflation into account.

Total Returns vs Total Wealth vs Total Real Returns

Total Returns

Total returns means that all returns, such as interest and dividends and capital gains, are automatically reinvested in the asset and allowed to accumulate over time.

A graph depicting the total return indexes for stocks, long- and short-term bonds, gold, and commodities from 1802 through 2001, showed that the total return on equities dominates all other assets. Even the cataclysmic stock crash of 1929, which caused a generation of investors to shun stocks, appears as a mere blip in the stock return index. Bear markets, which so frighten investors, pale in the context of the upward thrust of total stock returns.

Total Returns vs Total Wealth

However, the total wealth in the stock market, or in the economy, does not accumulate as fast as the total return index. This is so because investors consume most of their dividends and capital gains, enjoying the fruits of their past saving.

It is rare for anyone to accumulate wealth for long periods of time without consuming part of his or her return.

• The longest period of time investors typically plan to hold assets without touching principal and income is when they are accumulating wealth in pension plans for their retirement or in insurance policies that are passed on to their heirs.
• Even those who bequeath fortunes untouched during their lifetimes must realize that these accumulations often are dissipate in the next generation.

The stock market has the power to turn a single dollar into millions by the forbearance of generations - but few will have the patience or desire to let this happen.

Total Returns vs Total Real Returns

The focus of every long-term investor should be growth of purchasing power - monetary wealth adjusted for the effect of inflation. The growth of purchasing power in equities not only dominates all other assets but also shows remarkable long-term stability. Despite extraordinary changes in the economic, social and political environments over the past two centuries, stocks have yielded between 6.6 and 7.0 percent per year after inflation in all major subperiods.

The wiggles on the stock return line represent the bull and bear markets that equities have suffered throughout history. The long-term perspective radically changes one's view of the risk of stocks. The short-term fluctuations in the stock market, which loom so large to invetors when they occur, are insignificant when compared with the upward movement of equity values over time.

In contrast to the remarkable stability of stock returns, real returns on fixed-income assets have declined markedly over time. From 1802 to 1926, the annual real returns on bonds and bills, although less than those on equities, were significantly positive. However, since 1926, and especially since World War II, fixed-income assets have returned little after inflation.