I want now to switch the discussion to a very important topic — realistic expectations of investment returns. It's an important discussion, because for some reason many investors assume they're going to achieve outstanding returns simply because they're attempting to do so. It's a bit like that survey in Sweden that found that 90 per cent of drivers considered they had above-average driving skills. If it were true then it would definitely pay to get the other 10 per cent off the road quick smart!

The reality is investment returns are largely pedestrian. Even so, the wonders of compounding mean the patient investor can achieve a great return over time. If they're capable of achieving annual returns a few percentage points above average, then over time they'll achieve an outstanding result. So let's get a handle on what those realistic expectations should be.

In late 2009 I attended an investment expo. It was an interesting day but unfortunately the organisers let a spruiker up on stage. Maybe he'd curried favour with the event organisers — certainly, the large sales stand he'd hired at the expo to peddle his ‘investment product' must have cost him a pretty penny.

He enthusiastically told us he knew how to make guaranteed profits from trading options and SPI futures contracts. The secret was locked up in his options trading software. And with pretty-coloured graphs projected on the auditorium wall he showed us how to make bucketloads of money by simply following the trading cues his software delivered. After winding up his presentation, he headed back to his sales stand. People followed him over and started swarming around the stand like bees around a honeypot. They stood three deep as attractive young saleswomen signed them up to year-long contracts.

I also went over to his sales stand, but purely out of interest. I listened to a spiel from one of the contract-bearing saleswomen and then left, shaking my head in disbelief. This was the claim: the trading software would deliver annual returns of 200 per cent, tripling your money every 12 months.

Several months later I was invited to deliver a series of lectures in capital cities down the east coast of Australia. The topic was asset allocation, and the theme of the day was to answer a hypothetical question: how best to invest $1 million? I was up on stage straight after lunch. And with my tongue very much in my cheek I started my presentation by telling the audience about the options trading software I'd seen earlier in the year:

You guys have wasted your time listening to the earlier presentations today. You should have put me on this stage first thing this morning. I would have had the whole day's proceedings wrapped up by 10 o'clock this morning and then we could have all gone home. What to do with your $1 million is answered simply. Just invest using some options trading software I recently stumbled across. It triples your money every year — guaranteed, I was told. Which means in 10 short years your $1 million would be transformed into $59 billion and you'd be rubbing shoulders with the wealthiest people in the world. You might even be worth more than Warren Buffett and Bill Gates, because those two guys are pretty busy giving their money away at the moment. In 20 years you'd be worth $3500 trillion, enough to pay out the US national debt 240 times over. So ring the US President now. Tell him not to lose any more sleep worrying about that infernal debt problem. Tell him you've got it all worked out. Options trading? Sounds too risky to your ears? Okay then, rather than a million dollars just put in $10 of your money. I'm sure you all feel more comfortable about that. And in 20 years you'll be worth a more conservative $35 billion!

The audience got the point.

That day I also spoke of returns on property — that most Australians had unrealistic expectations regarding the long-term returns property delivers. This certainly wasn't the case in the US, given their relatively recent subprime meltdown. But Australian property prices had passed through the subprime crisis unscathed, and at the time of the presentation Australian house prices had experienced over two decades of capital growth at a rate that had significantly outstripped the national inflation rate. In fact, over the prior 24 years the real (inflation-adjusted) capital gain on property had averaged 3.6 per cent per year. That figure didn't raise an eyebrow in the auditorium. Three point six per cent; maybe some people thought the figure was too low. I knew it was correct, and I also knew it was outrageously high by long-term standards.

I went on to discuss my favourite property study, that of Piet Eichholtz from Maastricht University in the Netherlands. His study looked at property prices on Amsterdam's Herengracht, or ‘Gentlemen's Canal'. He had access to over 300 years of meticulously kept sales records on the same houses; hence it provided a constant quality index virtually unheard of in any other real estate study. Eichholtz looked at property price movements between 1628 and 1973 and found that the annual geometric inflation-adjusted capital gain was a mere 0.2 per cent. Doesn't sound much but it sits within the realm of what one should realistically expect. A greater rate was unlikely because it would have meant the properties had become unaffordable — clearly something that can't happen in a functional marketplace.

Eichholtz found that property prices:

• were volatile (capital growth in sub-periods of the 345 years was quite irregular) and
• showed little real (inflation-adjusted) capital growth when viewed over the long term.

The study also showed there were prolonged periods when real property prices didn't go up at all. For example, if a single family had owned a Herengracht property during the 100-year period between the 1850s and the 1950s, not one inflation-adjusted dollar would have been made. The point my Australian audience was missing is that residential property is very much about affordability: no buyers, no sales. Affordability is ultimately linked to people's incomes, and hence to inflation. The relationship between house prices and affordability is also linked to mortgage rates. For example, the affordability of an interest-only $200 000 mortgage at a rate of 10 per cent is the same as that of a $400 000 mortgage at 5 per cent. Hence the tendency is for house prices to receive a boost when interest rates fall and to take a hit when interest rates rise. But, over the very long term, the influence of fluctuating interest rates on prices tends to be a zero-sum game.

The fact is that Australia had seen interest rates fall from 15.5 per cent to 6.5 per cent in the 24 years preceding my presentation. This meant it was possible for the inflation-adjusted price of a house to double without introducing any additional mortgage stress to debt-funded property owners. And that's exactly what had happened. Property prices had doubled in real terms over the preceding 24 years (hence the 3.6 per cent annual real growth). It was a powerful explanation as to why Aussie property prices had risen in real terms.

Some members of the audience were still having trouble digesting Eichholtz's long-term capital appreciation rate of 0.2 per cent. They felt more comfortable with the Aussie figure of 3.6 per cent. I explained it was absolutely ludicrous to expect property prices to continue to appreciate at 3.6 per cent real over the long term. And to demonstrate I plugged 3.6 per cent into the 345-year Herengracht example. At an annualised real increase of 3.6 per cent, a modern-day citizen of Amsterdam would need to pay nearly 200 000 times the real (inflation-adjusted) price for a Herengracht house that a citizen did back in the 1620s! This means that if a Herengracht house cost the equivalent of $500 000 (in today's money) back in 1628 then today it would cost $100 billion. Ridiculous expectations (3.6 per cent) require ridiculous answers. One audience member remained unconvinced: ‘The figure you gave of 3.6 per cent was for 24 years', he said. ‘That's long term in my book. I'm not going to be around in 345 years.' It seemed my blunt message was just too subtle for him. So I moved on.

I regularly hear of unrealistic expectations of share market returns: investors who expect consistent annual returns in the order of 20 to 30 per cent and are impatient to know when the share market will make them rich. As a friend of mine likes to say, ‘Patience, Grasshopper.'

When compared with other asset classes, such as property, the share market has historically delivered exceptional returns. There are no rules about what those returns will be in the future, but if the past has been any guide then expect long-term returns more in the order of 10 per cent per annum (with dividends plus capital returns), and 7 per cent if you adjust those returns for inflation. Given the heady prices paid for stocks in 2015 returns are likely to be lower than this over the medium term.

Higher-than-average returns could be delivered if you develop market-beating skills — or are just plain lucky.

Chapter summary

• Annual investment returns from all asset classes are largely pedestrian when considered on a geometric average basis over a long period.
• The wonders of compounding mean the patient investor can achieve a good return given sufficient time.
• Realistic expectations of long-term capital gains on real estate (excluding rental returns) should be aligned with inflation.
• Real estate prices can and do underperform and outperform the inflation rate during sub-periods, and sometimes for decades.
• Realistic long-term stock market returns should sit in the medium to high single digits (inflation-adjusted capital gains plus dividends).
• Returns exceeding average returns might be due to skill, luck or a combination of both.