I recently wrote a post saying that investors should not expect an 8% return on a long-term basis by investing in the broad stock market.  This is particularly true if you account for inflation.  If the economy cannot even grow at an annual rate of 3% – even according to the government’s own statistics – why should we expect an easy 8% return that is sustainable?

It is easy right now to think that an 8% return is a reasonable assumption, given that stocks are hitting all-time nominal highs, while the government’s reported consumer price inflation is relatively low.  The problem is that we go through bubbles and busts, and we don’t know when the next bust is going to hit, or how hard it is going to hit.

While the government’s CPI numbers are showing price inflation to be around 2% per year, this likely understates the impact of the Fed’s monetary policy.  True inflation is the increase in the money supply.  The rising prices are one effect of this.  If productivity is still increasing, or the demand for money is increasing, then the price inflation numbers may not be telling us the full impact of the Fed’s previous loose monetary policy (2008 to 2014).

Therefore, even if we do get an average of an 8% return on stocks, actual inflation could be higher than the reported price inflation of approximately 2%.  If actual inflation is, let’s say, 4%, then your 8% return is really just 4%.

I cannot predict what nominal returns on stocks will be over the coming years.  It could be negative.  It could be flat.  It could be 100% over the next decade.

Here is the problem.  If consumer prices double over the next decade along with stocks, then your 100% return is actually nothing.  Actually, it is worse than nothing because you will owe taxes on your 100% “gain”.

In a world without any monetary inflation, the broad stock market index would not likely see wild swings.  Over time, it would not go up or down a lot.  Individual stocks would certainly go up or down depending on their profitability and their future outlook for profitability.  But the broad market would not likely see significant capital gains.

This does not mean it would not be beneficial to own stocks.  You are owning a piece of a company.  The company can pay dividends.  In a free market, a company likely would pay dividends if it is profitable.

You would also be gaining purchasing power.  If you own a stock that pays an annual dividend of 3%, and you sell it 5 years later for the same amount you paid for it, then in a free market setting without monetary inflation, you would likely have gained purchasing power.  It would have been the same as holding it in cash.  But by taking the risk of investing it, you got an annual return of 3%, plus the gain in purchasing power.

I am not saying we should live in a world with no monetary inflation, but I am saying that it would overall be beneficial as compared to what we have now.  In a true free market, it would be up to the market to decide what to use for money.  Historically, this has been gold and silver.  Even with gold and silver, there is some inflation due to more of the metals being mined from the ground.  But this requires extensive capital and labor in most cases, and it is not a political event.

My main point here is that stocks have been highly politicized with government regulations, taxes, and the Fed’s monetary policy.  In a true free market, we would be looking at more dividends and less in the way of capital gains.  The only reason the broad stock market goes up is because of monetary inflation.  And what the Fed giveth, the Fed taketh away.

In other words, you can’t have the bubbles without the busts.  It is a highly distorted market.  But it doesn’t just go one way.  Unless the Fed goes towards hyperinflation (which I don’t think it will), then you can’t expect for stocks to always go up, even in nominal terms.

I think there is a place for stocks in a well-diversified portfolio.  In the permanent portfolio, the recommendation is to hold 25% in stocks.  But I think it is a bad idea to think you are going to get anywhere close to an 8% return by investing in stocks, particularly if you take inflation into account.