Returns that cannot exist

Three percent a month. It is a modest-sounding number, which is the point — it sits below the threshold at which people become suspicious, and well above anything that has ever been sustained.

Compounded, three percent a month is a little over 42% a year. Start with 10,000 and leave it alone for thirty years at that rate and you finish with somewhere over 400 million. Leave it fifty years and the figure runs past 500 billion, from a starting sum most households could assemble.

That is the whole argument of this lesson. A rate is not a property of an investment. It is a claim about the entire future output of the world, and most claimed rates are claims that the world will be several times over.

Feel the curve

The model below tops out at 25% a year, which is well under half of the implied rate above. Start with 1,000 and find the year it passes a million.

Compound growth

≈ Hypothetical model, not a forecast

Grows a starting balance plus a fixed yearly contribution at a constant rate.

It assumes

• The same return arrives in every single year, which no market has managed.
• Nothing is withdrawn, no fee is charged, and no tax is due anywhere.
• Growth is credited once a year, with no compounding inside the year.
• Every figure shown is nominal, so rising prices have not been taken off.

It ignores

• Tax on growth, income or withdrawal
• Platform fees, spreads and trading costs
• Inflation — every figure shown here is nominal
• Any year in which the return happens to be negative

Leave the rate at its maximum and the starting balance at 1,000. Find the number of years at which the balance passes a million.

Annual return25%

Years20

Final balance

86,736

Total paid in

1,000

Growth

85,736

Growth as a share of the final balance

0.988

• Balance

◷ Not there yet — keep moving the controls.

Around thirty-one years, from a thousand, at a rate roughly half the one in the pitch. That is the reason this arithmetic is worth doing before evaluating anyone's credibility: the number defeats itself without any reference to who is offering it.

Predict

An operator has genuinely produced 3% a month for eleven consecutive months. What does that establish?

Choose one answer

That the strategy works — eleven months is a real recordNothing about whether it can continue, and nothing about where the money came fromThat the operator is skilled, since chance alone rarely produces elevenThat the returns are real, since they were paid out

Lock in answer

Where returns actually come from

There are not many sources, and listing them is a useful discipline because every real return is one of these and every claimed return has to be assigned to one.

Production. A business makes something and sells it for more than it cost. This is the only source that creates rather than moves, and it is bounded by how fast real output grows.

Rent. Something you own is used by someone else who pays for the use. Bounded by what the use is worth to them.

Lending. You give up money now for more later, and the extra is priced by the risk of not being repaid. Higher rates here are not a better deal; they are a description of how likely you are to lose the principal.

Repricing. Someone pays more for the thing than you did. Nothing was produced. This can be large and it is a transfer, which means somebody else's position is the mirror image of yours.

Other people's deposits. Not a return at all, and the subject of the next lesson.

Not the same thing

A high return

A large payment relative to the amount committed, over a period.

Measured in

Percentage per year, and how many years it held

For example

A concentrated position that rose sharply over two years.

Chase it alone and

It says nothing about repeatability, and the highest ones are usually the least repeatable.

A high sustained rate

The same large percentage, achieved every period, indefinitely.

Measured in

The implied total after ten, thirty and fifty years

For example

Nothing that has ever existed at the rates commonly claimed in pitches.

Chase it alone and

It is a claim about the size of the future economy rather than about an investment, and the arithmetic refutes it without any other evidence.

Which is which? Put each one on a side.

• A business that grew tenfold over eight years and then settled

  A high returnA high sustained rate

• A monthly figure presented as what the arrangement produces, ongoing

  A high returnA high sustained rate

• A rate quoted per week, with an annual figure never mentioned

  A high returnA high sustained rate

The two questions that follow

Once a rate has been converted to an annual figure and compounded out, two questions do most of the remaining work.

Which source is this? Production, rent, lending, repricing or deposits. Every real return is one of them. An answer that does not fit any of the five, or that requires two of them at once in ways that cannot be separated, is worth a great deal of attention.

Why is this available to me? If a mechanism reliably produces several times what capital normally earns, the constraint on it is not the supply of customers. Anyone with access to it can borrow at ordinary rates and keep the difference, which is a far better business than selling participations. A mechanism being offered rather than used is information about the mechanism.

Check

A proposition offers 1% a week and says the figure is conservative. What is the most useful next step?

Choose one answer

Ask for the audited record of the last three yearsCompound it out to a year and then to ten, and see what is being claimedCheck whether the operator is registered with an authorityStart with a small amount to test whether the payments arrive

Check answer

Worth remembering

• A sustained rate of return is a claim about how fast real output grows, because returns have to be paid out of something produced.
• Compounding a small-sounding periodic figure out to a year and then a decade defeats most claimed rates without any other information.
• Quoting a rate weekly or monthly rather than annually is a technique, and the annual figure is always available.
• Real returns come from production, rent, lending or repricing, and every claim should be assignable to one of them.
• A mechanism that reliably beats the cost of borrowing would be used rather than sold, so being offered it is itself information.