The market has finally staged a retreat just as we were all high-fiving one another about the great returns we have seen.
It is so easy to get caught up in the volatility of the markets that it is worthwhile pausing every so often to ponder the larger picture.
Consider the expectations we place on our hard-earned money when we invest it. Market volatility aside, many investors forget that, for most of us, the main goal of investment is to get a decent return ahead of inflation and to achieve it in a relatively smooth way.
The return you get over a period of time over and above inflation is called the real return. This is an apt term, because it is this number that will determine how many goods you can buy once you retire and live off your investments. So, how much is a decent real return for equities, given that we should get a little extra because of the volatility in share prices? It would seem that many people would like an annual return of about 20 percent.
Inflation has been significantly lower for some time now. This should be the basis of your expectations. The measurement of the inflation rate can always be improved, and the discovery of any errors can make an economist's career, but as long as we see a downward trend over a long period of time, and a level that is neither extremely low nor extremely high, that is more meaningful than the number. It is worth reminding ourselves that the inflation rate for the 1980s was 15 percent, peaking over 20 percent. In the 1990s, it averaged 10 percent, and so far this decade we have seen an average of 5.7 percent.
Of course, the question is the sustainability of this trend. There are many factors that determine inflation, but the power of the authorities who have set the inflation targets must not be under-estimated. As long as we can see that the target range is being taken seriously and that the actions of the Reserve Bank are consistent with their intentions, we stand a good chance of reaping the benefits of lower inflation. These include a more stable currency and interest rates, a better environment for businesses to plan and grow, more affordable goods and investor confidence, to name a few.
No comment about inflation would be complete without some mention of the oil price. A tank of petrol now costs nearly the same as a DVD player - that is, if your cellphone provider is not giving you one for free when you renew your contract. It is of some comfort to note that petrol prices only become inflationary if they keep rising, and at a faster rate than the year before. Compare this to eating too much - one good dinner may add a little weight, but it is eating a little too much every day over a long period that really does the damage and is the hardest to fix.
However, a sudden oil price increase of, say, five dollars a barrel (10 percent) does have an effect on inflation and can slow down economic growth by about 0.4 percent for the following year if it stays that high. So while we should be concerned about higher oil prices, it is possible that the fears about their impact on inflation may be exaggerated. If you assume that we believe in the success of inflation targeting and that we should see inflation below six percent, then 20 percent as an expectation of long-term returns in the share market suddenly appears a little unrealistic. Even if you add a hefty premium to the inflation number to compensate for the uncertainty in the stock market, it is still hard to get to 20 percent.
The success of your investment plan will depend heavily on your expectations, and it pays to think about those very carefully at all times, to keep them realistic and to temper them if necessary.