Gyroscopic Investing

Hi all,

i am trying to do my own statistics, and end up with a couple doubts i would appreciate if anybody can help me :-).

If i want to backtest a portfolio (portfoliovisualizer.com is an amazing tool), and double check how it evolved through time for a personal accumulation process, as far as i am seeing, you have to work with nominal annual CAGR returns (if you want to add annual contributions, you can adjust it by inflation or annual wage increase for instance). The objective is to obtain the value of your portfolio today, in actual $, so you have to use nominal CAGR. So this is my first question: whats the purpose of providing real CAGR (inflation adjusted)? to provide an easy way to calculate future returns? Why i am doing wrong if i use REAL CAGR for a past portfolio simulation?

My second doubt is about how to study falls in value through history. In all simulations i have read, they all start indexed in 1, reinvesting dividends & coupons, no annual capital contribution, rebalancing if using more than 1 asset, but some of them use REAL CAGR year per year, and others NOMINAL CAGR year per year. My second question: As far as i understand, if you want to study just falls in value, do you have to use REAL CAGR?

thanks in advance! :-)

Arturo wrote: The objective is to obtain the value of your portfolio today, in actual $

The key word is "value".  Nominal CAGR describes the numerical dollar amount in your bank account.  Real CAGR describes the value of the account balance in terms of purchasing power.  The difference is very important.  For example, looking at stock returns in the 70's you'd think by looking only at nominal returns that people were getting rich.  But once you account for the extremely high inflation you realize many were actually losing purchasing power and becoming less wealthy in the process.  In general, real returns are the only ones that matter because nominal returns greatly overstate the value of a given account balance. 

Regarding your second question, again it comes back to"value".  If you put all of your money in cash, your account will not fall in nominal terms.  But it does fall in real terms, as over time things get more expensive.  IMHO, real purchasing power is the more valuable measure. 

BTW, if you like PortfolioVisualier check out the calculators at PortfolioCharts.com.  Based on your questions, I think you might find this one particularly interesting. 

Hi Tyler,

thank you very much for your time.

When Craig Rowland provides PP historic performance starting with 10.000$ in 1971, he provides nominal returns (specifically nominal CAGR). When you apply for a simulation on portfoliovisualizer.com, they provide the detailed year per year accumulation in nominal. When you enter peaktotrough.com, they provide historical nominal returns. I mean, as far as i understand, and may be wrong, real CAGR looking at the past is really useful in terms of how much above inflation you portfolio performed. But if you want to know how much a portfolio accumulated from the past to nowdays, dont you need nominal?

For instance, in Craig Rowland simulation, he starts with 10.000$ in 1971 (by the way, its almost 29.000$ in 2014 prices), and ends up with $429,041 in 2012. As far as i understand the calc, this $429,041 are real purchasing power, real value today. If he calcs minus CPI, you are not getting real actual purchasing power, but something i dont understand at all :-).

If i want to make a simulation in terms of the future, as far as i understand, i should account for inflation. Lets say that an asset allocation gave the last 40 years 8,5% real CAGR, and you want to proyect a calc to the future. Lets say, how much a guy could get in 40 years? if you use real CAGR, you are directly calculating your accumulation in 40 years, but in actual value, actual cost, actual $ prices.

There is something missing to me.

By the way, amazing link http://portfoliocharts.com

Arturo wrote: For instance, in Craig Rowland simulation, he starts with 10.000$ in 1971 (by the way, its almost 29.000$ in 2014 prices), and ends up with $429,041 in 2012. As far as i understand the calc, this $429,041 are real purchasing power, real value today. If he calcs minus CPI, you are not getting real actual purchasing power, but something i dont understand at all :-).

Yeah, inflation can be confusing sometimes.  It's a matter of perspective.

I assume you're referring to Craig's post here:  You're correct -- those are nominal returns.  For tracking the amount of money that shows up in your bank statement over time, nominal returns are the proper measure.

However, it's important when looking either forward or backward to realize that the numbers will always be deceiving if you only think about them in today's dollars.  Referring to Craig's post, the $429k is the amount of money that the hypothetical investor would have had in his account in 2012 after investing $10k in 1971.  However, $10k in 1971 was a lot more money than it sounds like today -- the median household income in 1971 was only $7700, and the median house price was less than $30k!  Adjusting for inflation so that the start value in 1971 is $10k in today's dollars as we intuitively understand them, the endpoint in 2012 was only $77k. 

Inflation is a silent beast that is constantly devouring your bank balance without you even realizing it.  The real numbers are more valuable than nominal for determining "wealth" because they place the absolute returns values in the proper context relative to prices.

Hi Tyler,

excellent tip. i never though this way about those $10k in 1971 in terms of median wages :-).

so as far as i understand your help, if i want to know how much money you got coming from the past, you have to use nominal terms. real terms is just a way of having fast information about how much your asset allocation performed above of inflation, or if you want to create a kind of possible future simulation. Is it right?

so, does it make sense to make a past compound interest calc (like Craig Rowland one) using past real CAGR? :-)

thanks

It comes down to your purpose of the test.  Use nominal returns if your goal is to count dollars.  Use real returns if your goal is to count wealth.  Because of inflation, dollars and wealth are not the same thing. 

For the real returns of the PP, try this.  It's based on the same source data that Craig used. 

Tyler, your charts are amazing, beautiful and useful :-).

My last question :-) (i hope i am not bothering you). In here http://pages.stern.nyu.edu/~adamodar/Ne ... retSP.html i found historical total returns for stocks, bonds and bills. As far as i understand them, they are in nominal, since CAGR for stocks 1928-2014 is 9.60%, and for long bonds 5.0%, so when you sustract 3% annualized inflation, they provide the famous historical returns (6,60% for stocks and 2% for bonds). But when i double check historical CPI figures for US (1928-2014) in here http://www.usinflationcalculator.com/in ... ion-rates/ (coming from BLS), and i sustract this CPI figures to CAGR long bonds year per year, almost all REAL CAGR years are in negative, and the result is nothing to do with a 2%.

What am i doing wrong? Do you know where can i can obtain REAL CAGR for 10y bonds in XX century?

thanks again for your time and support :-)

I use the same spreadsheet for 10-year t-bond data.  So that seems fine.  The Inflation data also looks fine to me.  So it probably comes down to your calculations.

What you want to do is:

1) Calculate the nominal return for your asset allocation for the year
2) Adjust that for inflation for each year.  The simple way is to subtract inflation from the return.  The better mathematical way is to us the equation (Nom%-Infl%)/(1+Infl%).  For low inflation the result is very close.  With high inflation it makes more of a difference.
3) Calculate the CAGR from the inflation-adjusted returns. 

It sounds like you might be skipping step 2 and subtracting inflation from the CAGR.  That will cause problems.

Does that help?