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Fundamental Factors in Determining Investment Return

As you know, the whole point of this blog is to encourage people to focus on the basics of investing while ignoring everything else. So for today we have the two fundamental factors in determining investment return.

  1. How much money is the investment expected to pay?
  2. How predictable is the payout?

It really is quite simple, but a little explanation probably wouldn’t hurt.

How much will the investment pay?

We’re not talking about a rate of return here. We’re talking about an amount of money. For example, a bond might be expected to pay $500 every 6 months for the next 10 years.

Of course, with many investments, this is clearly an estimate. For example, we can see that a given stock is paying X dollars in dividends each quarter, but we then have to make guesses as to whether that amount will increase, stay the same, or decrease.

How predictable is the payout?

All else being equal, investors will pay more for an investment that will reliably pay $500 per year than they will for an investment that will perhaps-pay-somewhere-around $500 per year. And that makes perfect sense.

As a result, the investment with the reliable payout will have a lower rate of return. (Paying more for a given payout by definition means a lower rate of return.)

All the factors that might make the payout on an investment less predictable are what are known collectively as “risk” (according to the traditional technical definition).

How to take advantage of this knowledge

Here’s the most important part: When investors consider the predictability of an investment’s payout, they look almost exclusively at short-term predictability.

As a result, stocks (unpredictable over the short-run) end up being priced such that they have a greater rate of return than bonds (fairly predictable over the short-run) and a much greater rate of return than CDs (very predictable over the short-run).

What’s so great for long-term investors, though, is that long-term stock payouts (for big enough groups of stocks, anyway) are actually relatively predictable. And this “high return plus predictable payout” is precisely what makes stocks so great for long-term investors.

Hopefully, if we can keep in mind the fact that there are fundamental reasons why stocks will earn more than other investments over extended periods, we can do a better job of keeping our heads during down markets. 🙂

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