What is a reasonable return on capital

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quantropy
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What is a reasonable return on capital

Postby quantropy » Tue Jan 12, 2016 10:09 am UTC

This thread isn't about the inequalities of capital distribution, so imagine that the people getting a return on capital are those of reasonable wealth seeking to build up a pension.

In Capital in the 21st Century Piketty tells us that in the 19th Century a rate of return of 5% was seen as standard. For much of the 20th century the return on shares with income reinvested has been around 9%. I would divide this 9% into 2% inflation, 2% economic growth and 5% pure return on capital. However, some people have predicted that the return on capital ought to shrink as time goes on - as the amount of capital grows, diminishing returns sets in. Following the recent economic crisis a pure return of 5% seems unlikely.

So the question is, should we to expect a return significantly less than 5% for the foreseeable future? There's an argument the other way, that with more and more automation we might expect a greater return on capital, but I'm not sure how reasonable this is.

There's also the question: if X% is the accepted rate of return on capital, when is it reasonable to accept less than X%? Suppose your luck is in and you inherit a small hotel worth $2000000. You decide to have a go at running it, but (taking X=5) does that mean you should feel obliged to making $100000 a year as return on capital on top of income for yourself, on the basis that you could have sold it and made that return by investing the money.

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Re: What is a reasonable return on capital

Postby leady » Tue Jan 12, 2016 12:00 pm UTC

So the question is, should we to expect a return significantly less than 5% for the foreseeable future? There's an argument the other way, that with more and more automation we might expect a greater return on capital, but I'm not sure how reasonable this is.


On average currently no, but its critical to also include returns with respect to what

With respect to the dollar then you've missed out the interest rate as a key factor in your calculations.

More automation actually reduces the return on capital massively, not increases it (at least from the overall margin perspective, rather than the return on the specific investment in the automation). Automation = commoditisation = cheaper. Wallmart and Amazon run on tiny margins.

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Re: What is a reasonable return on capital

Postby Tyndmyr » Tue Jan 12, 2016 4:05 pm UTC

It depends on risk. And of course, you must adjust for inflation.

There isn't a set "more capital leads to x" outcome. Some industries rely on critical masses, and simply cannot exist in societies that are sufficiently small or capital poor. If we look at a mature industry like farming, well, sure. Farming is now very capital intensive and very, very light on profits. It's been around for ages, and adding increasing amounts of capital above what is already invested will have diminishing returns.

Newer stuff works differently, though. Brand new tech can be quite profitable as there's a lack of market competitors yet, and lots of new discoveries to be made. You can of course crash and burn horribly, but them's the breaks. Being first or second to a market can be amazing, being the ten thousandth, well...it's likely that any bright idea you have has already been thought of, and is either pervasive or impractical.

So, as society gets bigger and more capable, we keep unlocking additional things that we can effectively do. Computing, spaceflight, all sorts of nifty tech. Unless and until that ends, and there is nothing more to discover and invent, there's not really a big reason to expect a serious change. Modern cutting edge stuff will become routine, but we'll explore new stuff. As to when the end of invention happens...that's almost pure speculation, and I think we're sufficiently far from it that we cannot reasonably predict it.

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Re: What is a reasonable return on capital

Postby LaserGuy » Tue Jan 12, 2016 9:56 pm UTC

quantropy wrote:This thread isn't about the inequalities of capital distribution, so imagine that the people getting a return on capital are those of reasonable wealth seeking to build up a pension.

In Capital in the 21st Century Piketty tells us that in the 19th Century a rate of return of 5% was seen as standard. For much of the 20th century the return on shares with income reinvested has been around 9%. I would divide this 9% into 2% inflation, 2% economic growth and 5% pure return on capital. However, some people have predicted that the return on capital ought to shrink as time goes on - as the amount of capital grows, diminishing returns sets in. Following the recent economic crisis a pure return of 5% seems unlikely.

So the question is, should we to expect a return significantly less than 5% for the foreseeable future? There's an argument the other way, that with more and more automation we might expect a greater return on capital, but I'm not sure how reasonable this is.

There's also the question: if X% is the accepted rate of return on capital, when is it reasonable to accept less than X%? Suppose your luck is in and you inherit a small hotel worth $2000000. You decide to have a go at running it, but (taking X=5) does that mean you should feel obliged to making $100000 a year as return on capital on top of income for yourself, on the basis that you could have sold it and made that return by investing the money.


One of the things that Piketty makes quite clear is that you can't make good predictions from short timescales. When he's talking about the 5% rate of return, he's taking a global average of pretty much the entire century, IIRC. The market average rate of return is going to go up and down depending on a lot of factors. That said, many firms have comfortably hit the 5% rate of return even including the recession--the Canada Pension Plan, for example, has an average real rate of return of 5.6% over the last 10 years.

On the whole, I wouldn't expect technology to have a huge effect on this. This value has been found to be pretty robust over the long term going through the Industrial Revolution, two World Wars, and the technological revolution since then. But, again, that doesn't mean that individual investments, like your hotel example, are necessarily going to follow this trend.

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Re: What is a reasonable return on capital

Postby quantropy » Wed Jan 13, 2016 8:16 am UTC

leady wrote:Wallmart and Amazon run on tiny margins.

Walmart may have a low profit as a percentage of turnover, but it makes up for it on volume, so that the earnings per share are about 7 to 8 % (about half of that is distributed as dividends). So I suppose 7 to 8% is the return on capital people expect.

Amazon is different, it's earnings are barely above 0.1%. This may be because Jeff Bezos would rather run a big business than make money, and others are willing to buy shares in such a well known company. Or it may be that they expect it will start making a lot more money in the future.
Tyndmyr wrote:Farming is now very capital intensive and very, very light on profits. It's been around for ages, and adding increasing amounts of capital above what is already invested will have diminishing returns.
The question then is: why do people put money into farming, rather than Walmart shares. One answer is that some people see themselves as farmers, and are willing to forego some return on capital to keep up this tradition. Or maybe people expect to make money on the appreciation of land values. However, thinking that the value of an asset will consistently increase at a greater rate than GDP looks like a bubble to me.

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Re: What is a reasonable return on capital

Postby Tyndmyr » Wed Jan 13, 2016 5:00 pm UTC

quantropy wrote:The question then is: why do people put money into farming, rather than Walmart shares. One answer is that some people see themselves as farmers, and are willing to forego some return on capital to keep up this tradition. Or maybe people expect to make money on the appreciation of land values. However, thinking that the value of an asset will consistently increase at a greater rate than GDP looks like a bubble to me.


Well, one answer is that it's already there, and it's fairly illiquid. Farming land can be sold, sure...but who are you going to sell it to? Another farmer. Likewise, tractors last a good while, barns and silos are there, and are not readily convertable to other markets.

You may have a significant amount of assets, but they're not convertable, and you end up in a situation where you can keep fixing things up at relatively low cost. It's a "buy a job" situation for someone getting into it, and that is indeed usually impractical....but not a lot of people are moving from the cities to take up serious farming. Overall, percentage of population involved in farming will probably continue to slowly decrease.

Not all investment is nearly so liquid as shares are.

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Re: What is a reasonable return on capital

Postby leady » Wed Jan 13, 2016 5:24 pm UTC

quantropy wrote:Walmart may have a low profit as a percentage of turnover, but it makes up for it on volume, so that the earnings per share are about 7 to 8 % (about half of that is distributed as dividends). So I suppose 7 to 8% is the return on capital people expect.

Amazon is different, it's earnings are barely above 0.1%. This may be because Jeff Bezos would rather run a big business than make money, and others are willing to buy shares in such a well known company. Or it may be that they expect it will start making a lot more money in the future.


Sorry those are tiny margins, not in the absolute sense (which is meaningless anyway), but in the ROI sense. Given you can get 4% back purely on putting your capital in a bank that really makes Walmarts really trival and Amazon in practice is essentially still losing money even whilst strictly making a profit :)

Amazon dreams of reaching Walmart heady heights of 7 %

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Re: What is a reasonable return on capital

Postby quantropy » Wed Jan 13, 2016 8:04 pm UTC

leady wrote: Given you can get 4% back purely on putting your capital in a bank that really makes Walmarts really trival

Well 7% isn't 9%, so maybe returns on capital are less now than for most of the 20th century, but I would think that Walmart is probably popular with pension funds. If another investment offered a greater return with a similar level of risk then I would expect shareholders to sell their Walmart shares and buy the higher return investment.

The thing is that asset values are variable, and you would expect them to change until everything gave a similar return. So if farming has low returns you'd expect the value of agricultural land to drop. And if Amazon is limited in how much profit they can make, you'd expect their share prices to drop. If this doesn't happen it suggests either

1: Non-financial reasons (but do people realise just what they're missing out on?)
or
2: An expectation that asset prices will rise (but if this isn't because of an even greater rise in returns then to me it says bubble)

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Re: What is a reasonable return on capital

Postby Tyndmyr » Wed Jan 13, 2016 8:13 pm UTC

quantropy wrote:
leady wrote: Given you can get 4% back purely on putting your capital in a bank that really makes Walmarts really trival

Well 7% isn't 9%, so maybe returns on capital are less now than for most of the 20th century, but I would think that Walmart is probably popular with pension funds. If another investment offered a greater return with a similar level of risk then I would expect shareholders to sell their Walmart shares and buy the higher return investment.

The thing is that asset values are variable, and you would expect them to change until everything gave a similar return. So if farming has low returns you'd expect the value of agricultural land to drop. And if Amazon is limited in how much profit they can make, you'd expect their share prices to drop. If this doesn't happen it suggests either

1: Non-financial reasons (but do people realise just what they're missing out on?)
or
2: An expectation that asset prices will rise (but if this isn't because of an even greater rise in returns then to me it says bubble)


Walmart is big too, and maturing. Only so many more walmarts you can make, at a certain point. But, being big, it has a certain stability. A bad year is low profits, not "oh god, we lost everything". Same same with farming land, to an extent. Land is always going to be there, barring highly unusual events. And farmland IS vastly less expensive than most kinds of land, as you would expect, but...there's a floor there. Security matters a ton.

Amazon is sort of a special case. They're trying to build and lock down a market. Playing a longer game. They're not consistently profitable yet(and marginally so, when they are), but that's because they're growth focused. In theory, once you've built out "enough", you start reaping profits. How much investment and patience is reasonable for the promised payout someday is a little subjective, but...I'll put it this way, I don't own Amazon stock.

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Re: What is a reasonable return on capital

Postby quantropy » Thu Jan 14, 2016 8:49 am UTC

So it looks like people think that typical long term returns of 9% are perfectly possible in future. I can see that if Walmart may be one of the low-risk options and so have lower returns, whilst many businesses have the potential for growth, and although some of these may not succeed so well, on average they do better than the 7% of Walmart.

I'd be interested to hear though whether there's anyone else who thinks differently - that the era of 9% returns has gone.

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Re: What is a reasonable return on capital

Postby leady » Thu Jan 14, 2016 10:05 am UTC

It depends on what you mean

9% yield on stocks - no chance - but this should never exist unless interest rates are at 7%
9% growth on stocks generally (DOW index etc) long term - shouldn't happen, but does occasionally over longish terms - typically due to high inflation, or things like the governments tax incentivising share ownership (80s & early 90s)
9% on general capital investments - absolutely depending on the industry, most companies won't even consider less than 20% planned ROI

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Re: What is a reasonable return on capital

Postby ijuin » Thu Jan 14, 2016 8:51 pm UTC

Generally speaking, if you are getting more than 120-130% as much profit as you would from interest-bearing insrruments such as bonds, then you are doing decently.

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Re: What is a reasonable return on capital

Postby Reko » Fri Jan 22, 2016 5:53 pm UTC

A couple of thoughts that came into my mind:
Being a farmer vs buying Walmart shares. One may be less capital intensive or provide a better return (I'm not going to run the numbers) but there are alternatives to looking purely at these options from a numbers perspective. Some people consider it their family trade and thats just what you do, no questions asked. It can also, depending on what is being farmed/raised, provide sustenance for the family, thus reducing the costs of groceries and what not (I don't know if that is included in the calculation or not). So it provides a great fall back if things go to hell in the economy or can be used for barter for other services, etc. Yes, costs are associated with this but if someone had acres and acres of crops, chances are even if a large majority failed due to lack of fertilizer or what not, the farmer and his/her family would do just fine. People are not perfectly rational profit maximizers, despite what the economists like to believe.

Mentioning a recent economic crisis as reason to not expect 5% returns - I don't know why this would be the case. the 5% returns are an average over a long time and across all industries, as another poster said. So there are plenty of companies or investments that perform well in excess of this and there are likely many many more that have returns of -100% as they go bust. The million dollar question is which one will be the winner before it is the winner?


Or maybe I didn't understand the nature of the post?

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Re: What is a reasonable return on capital

Postby Tyndmyr » Tue Jan 26, 2016 5:50 pm UTC

Also a matter of skills. Knowing how to farm and knowing how to run a retail store are not interchangeable skills.

Modeling people as fungible assets tends to break down if you're not fairly careful about it.

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Re: What is a reasonable return on capital

Postby johnfrmcleveland » Wed Apr 20, 2016 5:53 am UTC

quantropy wrote:So it looks like people think that typical long term returns of 9% are perfectly possible in future. I can see that if Walmart may be one of the low-risk options and so have lower returns, whilst many businesses have the potential for growth, and although some of these may not succeed so well, on average they do better than the 7% of Walmart.

I'd be interested to hear though whether there's anyone else who thinks differently - that the era of 9% returns has gone.


That depends on whether you are investing in something directly or not.

Most people still think that the money you deposit in a bank is used for loans, and the return on those loans is what pays you interest, but this is incorrect. Banks don't loan out deposits; when banks create loans, they do so by expanding their balance sheet, marking up borrower's account by the full amount of the loan, and creating a matching asset for themselves for the full amount of the loan plus interest. Nobody's deposits are used, and nobody's account balance goes down. The reason the bank wants your deposit is because your deposit brings with it the reserves they need to meet requirements, and paying you a tiny bit of interest is the cheapest way to attract those reserves. So the interest you receive is not because the bank is lending out your money, it's because the government is paying interest on reserves. In the old days, when a savings account was paying 5%/year, the overnight rate was greater than 5%.

When you invest in the stock market, unless you buy into an IPO, you are just buying secondhand stock, and the company isn't getting your money. If your stock pays dividends, those come out of company profits; but any increase (or decrease) in the price of your stock is coming from the pile of dollars people are parking in the stock market. While some stocks do better than others, the market as a whole does well when there are a lot of dollars looking for a home; what the economy is actually doing is secondary.

After learning that stuff, I kind of lost my will to play the stock market anymore. Doesn't feel safe at all.

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Re: What is a reasonable return on capital

Postby Tyndmyr » Wed Apr 20, 2016 2:38 pm UTC

johnfrmcleveland wrote:After learning that stuff, I kind of lost my will to play the stock market anymore. Doesn't feel safe at all.


Why on earth would anyone assume the stock market is safe?

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Re: What is a reasonable return on capital

Postby ucim » Wed Apr 20, 2016 2:57 pm UTC

johnfrmcleveland wrote:After learning that stuff, I kind of lost my will to play the stock market anymore. Doesn't feel safe at all.
If it were safe, you wouldn't make any money, would you?

Think for a moment about what wealth is. You can think of it as a "store of stuff-other-people-want", but I don't think that's actually right. Wealth can be stored that way, but that's not what it is. I see it as a backlog of incomplete trades. I have foo but want bar, you have baz but want foo. Baz is easy to convert into bar, so I accept your baz even though it's not what I want.

The incomplete trade here is foo <--> bar, and an old incomplete trade being consummated involves whatever it is that you did to get your baz, vs my foo. Baz is the hot potato that nobody wants in and of itself; we only want it because other people are willing to take it. The "medium of exchange" represents these incomplete trades, but it is those incomplete trades that make wealth up in the first place. It's an abstracted form of "you owe me bar".

For this to work, I (who have entered into an incomplete trade) have to have faith that I will get some bar later. Gold is historically a substance that people have put that faith into, but it is still faith. (Almost) nobody actually wants gold.
Spoiler:
...except as a tool for sex. Decoration used to get mates (sometimes through the intermediary of status) and such, and even so, it's the sex they're ultimately after.
So, even gold isn't "safe".

The stock market can be thought of as a way to get into the actual production of bar. Yes, they can be traded, but they fundamentally represent ownership in the making of (various kinds of bar) that are actively sought in their own right, not just as a medium of exchange.

It's not that stocks are (or are not) safe. Nothing is.

As to banks lending out deposits, the deposits are what create the ability to expand their balance sheet in the manner in which you describe, through the reserve requirements. If there were no reserve requirements, anybody could print money. (In fact, that is what you do when you write a check: You are printing money. It's short-term money because it will be cashed soon, but it in theory could circulate as n-th party checks, so long as people have trust that the check will ultimately be paid.)

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Re: What is a reasonable return on capital

Postby Tyndmyr » Wed Apr 20, 2016 4:11 pm UTC

Incomplete trades don't work to describe wealth.

By that standard, someone who never delivers, but has a huge backlog of work is wealthier than the one who delivers swiftly, and on time. Unless all your clients pay in advance, and are okay with endless delays, this doesn't seem reasonable.

Wealth is stuff(goods, services, whatever) people want. It isn't just things that are long term stores, but a wealthy person is described as such, even if he's reclusive and not making deals at all. If he has a private island, a yacht, etc, that dude is still wealthy, even if he doesn't give two craps about selling any of it.

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Re: What is a reasonable return on capital

Postby ucim » Wed Apr 20, 2016 5:27 pm UTC

Tyndmyr wrote:By that standard, someone who never delivers, but has a huge backlog of work is wealthier...
Wealth isn't owing, it's being owed.

Yes, having things (the dude on the island) also constitutes wealth, but much "wealth" now is in the form of proxy. Stuff you don't want in and of itself, but are storing up so that you can trade it for the stuff you do want. In this case, the stuff-you-don't-want just keeps track of stuff-you're-owed.

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Re: What is a reasonable return on capital

Postby quantropy » Mon Apr 25, 2016 11:14 am UTC

johnfrmcleveland wrote:After learning that stuff, I kind of lost my will to play the stock market anymore. Doesn't feel safe at all.

Not safe in the short term maybe, but in the longer term any ups and downs should average out, and typically stock market outperforms other investments such as bonds. When I say typically though, that is for the 20th century, So far this century it hasn't been the case. The question is, is this just a temporary aberration, or should we expect returns to be lower from now on? If you're investing a sum of money for 40 years then a 7% return will multiply it by 15, while a for 5% return it will be multiplied by 7 - there's quite a difference.
Another thing is, it's probably worth paying for investment advice (or investing in a managed fund), not so much to try to catch the large gains as to avoid large losses. But how much is it worth paying? You don't want fees to reduce your return from 7% to 5%, but if the plan is to try and get higher returns to maintain 7% after fees then maybe you're taking too much risk.

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Re: What is a reasonable return on capital

Postby ucim » Mon Apr 25, 2016 2:34 pm UTC

quantropy wrote:Not safe in the short term maybe, but in the longer term any ups and downs should average out, and typically stock market outperforms other investments such as bonds.
It's important to understand why the market typically outperforms bonds.

The stock market is a proxy for "turning dirt into goods". That is where the growth comes from. Wealth is the goods that used to be dirt, and it's made by companies (many of which are publicly owned). I'm glossing over the "goods that people want" part, and the "goods that enough people want" part - population growth helps fuel demand too, and this is what makes this company a better investment than that company. But that's the crux of it - wealth (and growth) comes from turning dirt into goods.

Other investments (such as bonds and metals) don't contribute to growth.

So, "safe" is a proxy for "people will continue to turn dirt into goods that other people want", and being good (enough) at figuring out (or averaging out) which companies do it best. Beyond that, there is no "safe" investment; in fact, a safe investment works against the very thing that fuels growth in the first place.

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Re: What is a reasonable return on capital

Postby Tyndmyr » Mon Apr 25, 2016 5:16 pm UTC

ucim wrote:
Tyndmyr wrote:By that standard, someone who never delivers, but has a huge backlog of work is wealthier...
Wealth isn't owing, it's being owed.

Yes, having things (the dude on the island) also constitutes wealth, but much "wealth" now is in the form of proxy. Stuff you don't want in and of itself, but are storing up so that you can trade it for the stuff you do want. In this case, the stuff-you-don't-want just keeps track of stuff-you're-owed.

Jose


Wealth INCLUDES stuff you are owed, but it also includes stuff you have. And of course, debt you owe others is negative wealth.

The fact that a LOT of debt exists right now doesn't tell us a great deal about total amounts of wealth. For every person that owes, another is owed. So, at the highest scale, debt is not a factor in determining wealth. How much debt you should have is a function of other things, and there isn't inherently a single right answer. But debt is merely a tool, creating it neither creates nor destroys wealth.

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Re: What is a reasonable return on capital

Postby ucim » Mon Apr 25, 2016 6:49 pm UTC

Tyndmyr wrote:Wealth INCLUDES stuff you are owed, but it also includes stuff you have.
Once you have all you need and want for the moment, the place where you "store" your excess wealth is some form of "stuff you're owed". That's what I'm talking about. If all you have is stuff-you-have (that's not a proxy, like gold bullion is), then you probably aren't wealthy.
Spoiler:
Influence is also a form of wealth; it's a personal form of "stuff you're owed", or will be owed.
And yes, stuff-you-owe counterbalances stuff-you're-owed. There's nothing new here.

The point I'm making is that wealth (by which I generally mean excess above the stuff you have that you want and use) represents stuff-you're-owed. It's measured and stored in dollars, ounces of gold, or bitcoin, but those are all proxies. They are not valuable in and of themselves, but rather, because they can be traded.

Tyndmyr wrote:But debt is merely a tool, creating it neither creates nor destroys wealth.
True. But in the overall sense, creating it and using it properly makes it possible (or at least easier) to create wealth, by turning dirt into goods and trading them for other people's favors, represented by the proxy of cash.

Jose
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Re: What is a reasonable return on capital

Postby Tyndmyr » Mon Apr 25, 2016 7:30 pm UTC

ucim wrote:
Tyndmyr wrote:Wealth INCLUDES stuff you are owed, but it also includes stuff you have.
Once you have all you need and want for the moment, the place where you "store" your excess wealth is some form of "stuff you're owed". That's what I'm talking about. If all you have is stuff-you-have (that's not a proxy, like gold bullion is), then you probably aren't wealthy.
Spoiler:
Influence is also a form of wealth; it's a personal form of "stuff you're owed", or will be owed.
And yes, stuff-you-owe counterbalances stuff-you're-owed. There's nothing new here.

The point I'm making is that wealth (by which I generally mean excess above the stuff you have that you want and use) represents stuff-you're-owed. It's measured and stored in dollars, ounces of gold, or bitcoin, but those are all proxies. They are not valuable in and of themselves, but rather, because they can be traded.


Nonsense. If you own an island or a yacht, those are things owned. That is wealth, in a very real sense.

Yes, you can choose to keep your money in some manner of debt owned. You do not have to. Redefining it as debt is inherently wrong, because it excludes a number of traditional ways that wealth is stored and displayed. The man with a giant mansion, a fancy car, and other things is not lacking for wealth.

Debt owned is a part of wealth. It is not equal to wealth.

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Re: What is a reasonable return on capital

Postby ucim » Mon Apr 25, 2016 8:21 pm UTC

Tyndmyr wrote:Nonsense. If you own an island or a yacht, those are things owned. That is wealth, in a very real sense.
Chances are, if you own an island or a yacht, that's not the only thing you own. You probably have much more wealth, sitting in the form of proxies. I'm not discounting the yacht as a form of wealth, I'm saying that the wealthy have most of it as proxies, rather than as things-they-are-using.

I could be wrong - I don't pal around with many billionaires. But I suspect.

Jose
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elasto
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Re: What is a reasonable return on capital

Postby elasto » Tue Apr 26, 2016 7:18 am UTC

I'd guess that's true almost by definition: 'Things-you-are-using' tend to depreciate in value - with the odd rare exception like home ownership - whereas 'wealth proxies' tend to, at worst, hold their value but more typically increase. That's why they get chosen as wealth proxies after all...

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Re: What is a reasonable return on capital

Postby quantropy » Tue Apr 26, 2016 9:32 am UTC

ucim wrote:It's important to understand why the market typically outperforms bonds.

The stock market is a proxy for "turning dirt into goods".

But remember that there are corporate bonds as well as government bonds. Dirt2Goods corp needs capital to do business, and there are a number of ways it can get the money for this. If it is buying long lasting stuff then it might get a mortgage, with a fairly low rate of interest. The lender then has the security that even if Dirt2goods goes bust, it still has some stuff in return for its loan. Alternatively Dirt2Goods can issue bonds, at a higher rate of interest (say 5%). Dirt2goods are obliged to pay this, but if they go bust then the investor loses their investment. Then there's the possibility of issuing shares. The risk here is higher, so the investor will expect higher returns.

The thing is that economics says that investors get a return on capital as compensation for not spending it immediately. The trouble is that with long term investments if your investments don't perform as you expected, it isn't possible to go back and change your choice. It's also a problem to know why they might have not have performed as expected - was it the particular investments, or has the whole market done badly. Maybe, even, the return on capital is going to be lower in the future than it was in the past.

What I'm trying to get an idea of is whether there is some level of return, say 7%, that people expect from investments with reasonable risk, and thus the businesses have to try to achieve.

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Re: What is a reasonable return on capital

Postby Tyndmyr » Tue Apr 26, 2016 9:09 pm UTC

quantropy wrote:What I'm trying to get an idea of is whether there is some level of return, say 7%, that people expect from investments with reasonable risk, and thus the businesses have to try to achieve.


The imprecision here is "reasonable".

Sure, people will generally want more return for more risk, but what level of risk is "reasonable" will depend on the individual, and some levels of risk may not be reasonable for any reward. Even if the payout were very good, most advisors would not advise highly risky investments for say, someone near retirement.

You can't feed in something so imprecise as "reasonable" and get out "7%".

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Re: What is a reasonable return on capital

Postby quantropy » Wed Apr 27, 2016 9:18 am UTC

Tyndmyr wrote:The imprecision here is "reasonable".

I guess I'm thinking of someone who is starting to invest for their retirement. They want to be able to plan for an income in retirement related to what they earn in work, and so need to have an idea of what return to expect. They're considering long term performance rather than short term gains. They also accept that nothing is entirely certain, but it's something they want to be able to plan for (rather than seeing it as a gamble)

Also, despite what johnfrmcleveland said about investing in secondhand stock, if you buy shares in a company then you have a vote, and if the management isn't producing the return you think they should then you can vote to sack them and employ someone else. But if you're planning to do this you need to have an idea of what a reasonable return in the first place.

Since such investments are long term, the market isn't going to come to some short term equilibrium reflecting peoples choices. Rather I think people must have some sort of feeling about what the return on capital should be. Piketty suggests that in a low growth economy 5% was typical. To this I would add 2% economic growth to give 7%. But Piketty seems to think that even 5% is too high. I'm trying to get an idea of whether people do have this preconceived idea of what the return on capital should be.

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Re: What is a reasonable return on capital

Postby Tyndmyr » Wed Apr 27, 2016 1:08 pm UTC

Assume for low risk, 5% + inflation if you're looking at "generalized expectations" for fairly low risk investing.

This is based on a number of retirement calculators, etc. Those probably represent baseline expectations better than anything else.

It isn't perfect, because a lot of people have CDs, money market accounts, etc that return lower than this, but usually those are shorter term than "until retirement".

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Re: What is a reasonable return on capital

Postby ucim » Wed Apr 27, 2016 3:23 pm UTC

quantropy wrote: if you buy shares in a company then you have a vote, and if the management isn't producing the return you think they should then you can vote to sack them and employ someone else. But if you're planning to do this you need to have an idea of what a reasonable return in the first place.
Investing in a company is very different from investing in "the market", especially if you want your hands on the steering wheel. A single company will have a seaish amount of very specific circumstances that go into what its profits will be, and how (and whether) they are distributed to stockholders or retained for growth. There is another seaish amount of very specific circumstances influencing public opinion about the company, which will dictate the (growth of the) stock price. These are often very different from "the market". You're evaluating the future of (say) garbage, or biotech, or electricity generation; whatever the company does, and you're evaluating how well the company does this thing, and how adaptable that particular company is to changes in the environment. All this is particular to the company.

Do not confuse this with the "spread the risks across everything" approach of (say) an index fund.

I don't think it even makes sense to attempt to derive "reasonable return on capital" from first principles. You need to look at actual historical data, and then make corrections for the specific environment of the historical data you are looking at, and for your guesses as to whether or not that's the environment we're in now, and will be in the future. By the time you do that, you have blurred the image way beyond the precision you seek.

One thing you could do for a clue is to look at bank interest rates. One way or another, the money you put in the bank gets invested in business, the bank takes a profit, and gives you the difference. You should be able to do better than this. How much better depends on how much smarter you are than the bank's investment professionals, and how much more honest you are than the derivative scammers. I remember something like 4% being the interest rate when I was a kid, but that's just one specific era, in one specific country. It spiked to 15+%, and it's now down so far that after fees, you are paying banks to hold your cash for you. If banking professionals can't get it right, random postings on the internet are not going to give you a better target number.

elasto wrote:I'd guess that's true almost by definition: 'Things-you-are-using' tend to depreciate in value...
but that's not what I'm on about. The ordinary may well have most of their assets in things-they-are-using, but the really wealthy have more assets than they can use right now. Those extra assets (which is what I'm mainly referring to as "wealth"), which they don't need now, but may want in the future, have to be stored somehow. That is where proxies come in.

Gold bars aren't something useful in and of themselves. Their primary use is to ensure that some time in the future, they can be traded for the favors-that-are-owed in exchange for the favors done to get the gold in the first place. And to the extent that you are not actualy running a company, stock also functions as a proxy. You can't eat stock (unless you are making soup); that stock merely holds your deferred favors for a while. Hopefully it grows moss as its doing so, but it's still a proxy for favors owed. And "favors owed" is the ultimate form of (excess) wealth.

Jose
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Re: What is a reasonable return on capital

Postby Tyndmyr » Wed Apr 27, 2016 4:42 pm UTC

ucim wrote:
elasto wrote:I'd guess that's true almost by definition: 'Things-you-are-using' tend to depreciate in value...
but that's not what I'm on about. The ordinary may well have most of their assets in things-they-are-using, but the really wealthy have more assets than they can use right now. Those extra assets (which is what I'm mainly referring to as "wealth"), which they don't need now, but may want in the future, have to be stored somehow. That is where proxies come in.


There really isn't an upper limit on what humans CAN use. Too much money to spend is...not actually a real amount. No such barrier exists.

Storing wealth for the future, physically, in promises, or otherwise, is something basically everyone does, though. Just, if you're poor, you probably don't use the same methods the rich do. Relying on children to take care of you might be a valid strategy, social repayment of neighborly debts, even if not tracked in a formal banking system, is a time honored thing.

Favors owed is a thing used by the rich and poor alike. It's just time shifting, it isn't necessarily "excess".

Gold bars aren't something useful in and of themselves. Their primary use is to ensure that some time in the future, they can be traded for the favors-that-are-owed in exchange for the favors done to get the gold in the first place. And to the extent that you are not actualy running a company, stock also functions as a proxy. You can't eat stock (unless you are making soup); that stock merely holds your deferred favors for a while. Hopefully it grows moss as its doing so, but it's still a proxy for favors owed. And "favors owed" is the ultimate form of (excess) wealth.


Gold bars are totally used for materials, yes. The fact that they happen to be a frequent means of exchange is mostly a matter of convenience and history. It's not that gold isn't also useful.

In fact, this is a good argument for fiat currency. It doesn't disrupt the shit out of a commodity market by making that thing more useful as currency than for most practical uses.

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Re: What is a reasonable return on capital

Postby ucim » Wed Apr 27, 2016 5:49 pm UTC

Tyndmyr wrote:There really isn't an upper limit on what humans CAN use.
That's not my point. However, there is an amount that an individual does use. The rest goes into savings (of one form or another). The rich can save more. The rich can also save proportionally more. That is what I mean by "excess" wealth (which I used to refer to as just "wealth").
Tyndmyr wrote:Favors owed is a thing used by the rich and poor alike. It's just time shifting, it isn't necessarily "excess".
It's "excess" by my usage of the word here. Yes, I'm overloading the word. I'm explicitly doing so.

My point is that "favors owed" is the fundamental basis of wealth. "Give me a hamburger today and I'll do you a (to-be-specified) favor* tomorrow." Money (be it fiat or otherwise) is simply a method of "condensing" these favors into a tradable unit, but the (unspecified) favor is its basis. You imply as much further up.
Tyndmyr wrote:Gold bars are totally used for materials, yes.
But not by people who are storing their wealth in gold. They don't own it to make circuits or jewelry or pretty books. They just keep it under their mattress until they need an unspecified favor.

Jose
*that favor could be giving physical goods to somebody, but needn't
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Re: What is a reasonable return on capital

Postby Tyndmyr » Wed Apr 27, 2016 6:44 pm UTC

Excess normally means "beyond a given level". It also has implications of extra, etc.

Investing is something that is done gradually more by the rich, obviously. But there isn't really the hard line implied. The poor invest. The rich still do spend. Personal use of resources does not have any absolute limit. The proportionally more is trivial, widely understood, and not what was conveyed by the actual words you used.

At a certain point, this "overloading" the word is simply using the word wrong. You're redefining everything in an increasingly circular argument that never actually gets any more precise at talking about return on capital. You want this to be "fundamental", but if you're not going to use reasonable definitions of words, I have no idea what you're actually trying to express.

Look at your gold discussion. You define gold as "not intrinsically useful". But it is. Obviously. You redefine your statement then to only apply to those who are not using it. Uh, okay. That's trivially true only in that you circled back around to defining away everything that contradicts your incorrect statement. That's useless and meaningless.

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Re: What is a reasonable return on capital

Postby ucim » Wed Apr 27, 2016 8:14 pm UTC

Tyndmyr wrote:You define gold as "not intrinsically useful". But it is.
Well, everything has some intrinsic use. But by and large, people who buy gold in order to hold their wealth are not taking advantage of its intrinsic usefulness. They are buying it for their ability to trade it away to get their favors back. This is a non-intrinsic use.

But I give up. I've forgotten why it was that I wanted to make the point, and getting distracted by the etymology of my definitions (intended to convey a specific idea in a specific thread) is of no purpose.

Jose
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Re: What is a reasonable return on capital

Postby ijuin » Thu Apr 28, 2016 5:02 am UTC

In the USA, federal government bonds are seen as the safest financial instrument, since anything that would cause the government to default on them would probably coincide with a major disruption in the US dollar (thus wrecking most other fixed-principal securities). This makes the federal bond rate the "lowest common denominator" of investment yield--any investment has to be either more stable than the federal government (very improbable for corporations), or offer a higher yield than federal bonds in order to attract investors. This is one of the ways that the Federal Reserve uses interest rates as a "throttle" for the economy--any investment that pays less than federal bonds gets crowded out. Setting the rate higher/lower thus raises/lowers the bar that other investments must jump over.

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Re: What is a reasonable return on capital

Postby quantropy » Thu May 05, 2016 1:19 pm UTC

I have to admit that the idea of a typical return on capital which long term investors such as pension funds tend to achieve, doesn't seem realistic, as pension fund returns do seem to be all over the place. So it seems that the best I can do is to look at the long term average returns on equities.

I'd also note that my breaking up the 9% typical returns into 5% +2% +2% needs modification. Inflation is probably higher, about 2.5% ~(it's hard to tell since there was substantial inflation in the 1910's when the US government started keeping records, but this was after a period of deflation). Economic growth for the USA is also higher, at about 3.25%, which leaves 3.25% pure return ~ a real return of about 6.5%. The long term return in the UK is about percent lower, which it seems is because economic growth is also about a percent lower.

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Re: What is a reasonable return on capital

Postby ucim » Thu May 05, 2016 3:12 pm UTC

quantropy wrote:So it seems that the best I can do is to look at the long term average returns on equities.
That's a start. Then break it up into different "eras" and assess the impact of conditions on the average return for each era you've chosen. That would give you an idea as to the source of these returns and how that evolves. Then consider what conditions are likely to prevail in the future, and how that might impact the average you're looking at. You might want to also break it up into sectors (manufacturing, information, health...) because at different times, different sectors do better for {reasons}.

And in terms of the returns that funds tend to achieve, they achieve these returns in part by constantly rebalancing and reallocating their capital, (within limitations dictated by the fund type) looking for the best returns, not the average returns.

Jose
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Re: What is a reasonable return on capital

Postby untitled » Sun Jun 12, 2016 3:54 am UTC

I can't give you a straight answer. I can give you a fair answer. The proper rate of "pure profit" can be defined as "if I sell you two, I can afford to buy one at the price I am paying for it." In other words, 50%. Therefore, the maximum fair return on capital would be 50% minus all the taxes you have to pay for it. For example, in the USA, 50% minus 40% taxes minus 5% insurance leaves you with 5% maximum fair return on capital, the same number you & Piketty brought up (although my calculation approaches the issue from the "other direction"). If I am not mistaken, the crisis made the insurance go up, which bites into the 5%. What can I say, the future is less predictable than it was and people are afraid.

This message was not sponsored by Global Insurance Inc.

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Re: What is a reasonable return on capital

Postby ParisNorway » Wed Aug 24, 2016 8:32 pm UTC

When I started taking interest in stock market, mutual funds and investing, I considered 15% a reasonable return on capital.
Now it's 9 years later and I consider 7-8% quite OK.
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