Thoughts on the rate of return on capital

20/08/2012 § 2 Comments

I’ve found myself wondering what the average rate of return on capital really is. Some of the numbers that get tossed around are an 8% average stock market return over the long term, a 15% to 20% risky rate of return for capital invested in a business, and an 8% to 10% rate of return for business generally (which is the basis for the country’s discount rate).

When I look at specific examples, though, that’s not what I see. Just for starters, the S&P 500 still hasn’t moved past its intraday high in 2000, over 12 years ago. Maybe a dollar-cost-averaging strategy would have helped, but this guy did the maths and found merely that it just reduced the losses. Residential real estate, a common Kiwi investment, depends on capital gains, as it is generally cash negative. When I look at businesses’ financial statements, many small businesses are just paying the equivalent of a wage to their owners. Of course, that calculation doesn’t even include the businesses that go bankrupt and produce a negative return.

And then think about infrastructure spending. Railroads, for example, were built with enormous sums of borrowed money, and then defaulted on a significant percentage of the loans. Proposed roads have low benefit-cost ratios — less than one in some cases. There are questions, too, about the gains from ultra-fast broadband.

This may just be the standard economic problem of making micro and macro pictures consistent. At the micro level, some investments do poorly, some businesses go under, and some time periods show weak returns. At the macro level, though, there is a clear trend.

The other thing it may show — other than my continued obsession with why things go wrong — is that good returns are not ‘normal’ and we shouldn’t expect them to be. Someone has to make 20% or 50% returns along the way, just to keep the averages up. If someone does it year after year, well, that’s pretty special. The rest of us chumps might have to settle for passbook rates.

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§ 2 Responses to Thoughts on the rate of return on capital

  • Andrew says:

    This low level of return seems to be a bitter pill to swallow for people of my generation Bill (gen Y). They were raised on the belief of continued and uninterrupted growth – but the last five years have kicked that in the guts! Purely by chance my wife and I have ended up owning an investment property with an ROA of ~ 8.5% due to it being a dual income property. Although I should be happy as larry I still we watch the financial markets with terror waiting for the next meltdown ;-)

  • Horace the Grump says:

    Do some reading… “What risk premium is normal?” Arnott & Bernstein, Financial Analysts Journal, Mar/April 2002

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