04 March 2008

The Diminishing Value of Capital - Entering an Age of Puny Portfolio Returns

Tom Stevenson of The Telegraph, summarizes Warren Buffet's take on reasonable returns:

Take the assumptions about future investment returns in corporate pension schemes. The average in America is 8pc, despite the fact that a quarter of pension funds are in bonds and cash (for which a 5pc return would be a reasonable expectation) and the rest in equities, which rose by just 5.3pc a year on average over the 20th century as a whole (a remarkable period of growth for the US economy).

Buffet suggests that expectations for returns are unreasonable based on history. Worse, I suspect that returns to capital will drop considerably over the next few decades for two reasons that are rarely mentioned.

1. There are trillions of dollars seeking returns. This money has driven up the price of stocks twice in the last decade, driven up the price of real estate for the last two decades, and is now driving up the price of gold and other commodities. This money is bidding up the price of various investment options because of a simple fact: the demand for investment returns is greater than the supply.

2. Related to this, many of the more exciting investment options are in ventures that don't require an enormous amount of capital. Or, more accurately, they require capital still not easily tracked or accounted for by accounting methods centuries old. Investments in Google have little to do with their banks of servers or buildings and almost everything to do with the ingenuity and knowledge of their employees. This is problematic for capital because it suggests that the best investment opportunities can be coy about their need for capital. Contrast this with the investments of a century ago; General Electric and General Motors represented investments that consumed huge amounts of capital.

As returns drop, it'll be easier for entrepreneurs to get money. Companies that expect to compete on the basis of returns to capital can expect to lag an already poor performing market. By contrast, companies able to foster a culture more like that of an incubator will prosper. For them, the cheap capital will be a boon, enabling them to seed even more ventures. These companies - and the investors who hold stocks in them - will be the big winners in this coming period of cheaper capital.


cce said...

Is it time for Ron to launch that fortune cookie company, with a little venture capital and some clever phrasing contributed by your fellow bloggers, you could dismantle the 401K and make your millions.

HRH said...

I'll invest in that because I believe you are right in #2.

Ron Davison said...

the wild ideas proliferate by the day; invest in my scheme for the hostile takeovers of blogs.

thanks for agreeing with me. Some days even I don't do that.

ronara said...

I think the idea that lower returns are here to stay is incomplatible with inflation, at least in the conventional sense. Even moderate inflation could act to consume disposible income on a larger scale, leaving LESS monies available for investing. This, of course, reduces the amount chasing the few good ideas, thus increasing returns. If you are talking about REAL returns (nominal returns less inflation), I need to think about that a little, but the low return model still seems lacking.