Real vs. Imaginary Returns – Part I

“The riskiness of an investment is not measured by beta but rather by the probability—the reasoned probability—of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And a non-fluctuating asset can be laden with risk.” — Warren Buffett, in his 2011 Berkshire Hathaway shareholder letter.

Diversified stock portfolios, e.g., index funds, have proven to be the best long-term investment available for reducing the real risk Buffett is talking about. Since 1928, U.S. stocks averaged about 9.9% nominal annual returns, translating to roughly 6–7% real returns after inflation. Bonds averaged 4.6%, cash 3.3%, gold 5%, and real estate 4.3%.

The following plots in these posts include a “MAX” function that allowed me to draw traces that locked in the peaks of the S&P 500 curves. Thus, you see thick cyan-colored table tops when the market dips for a while. Very cool. I haven’t seen this done before, but I don’t get around much.

I included P/E and CAPE ratios, which aren’t a core topic in these posts, but they don’t clutter the presentation and some of you will appreciate them. P/E is current market price divided by trailing 12-month earnings, and while not inflation-adjusted, the division removes its effect somewhat. CAPE is Shiller’s P/E that uses the same “P” but adjusts earnings for inflation and uses a trailing 10-year average. It’s a much improved look at the long-term, as shown in these plots.

Nominal S&P 500 1960–2025 Graph

The post-dot-com bubble of the 2000s is sometimes called the “lost decade,” but in real buying power it was actually about 17 years. Worse still, by far, were the three lost decades from 1965 to 1995. I haven’t seen this mentioned anywhere, but again, I don’t get around much.

I included a CPI curve that is useful in interpreting the differences between the nominal S&P 500 curve (lower) and the inflation-adjusted curve (upper). I also lightly shaded the real lost decades.

Real S&P 500 1960–2025 Graph

Investing is about preserving and growing usable wealth, which means what you can purchase, not how many units of the local currency you have. In mid-1922 Germany, the exchange rate for one US dollar was about 320 marks. By November of the next year, it was one US dollar to 4.2 trillion marks.

The goal isn’t numbers—it’s purchasing power—yet gains are usually measured with a nominal ruler. Becoming a millionaire isn’t the flex it used to be, and realizing this is foundational to financial wisdom.

(Graphs are high-resolution and should be viewed full screen. You can download them.)