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raids alio mentioned that the stock market is currently adjusting as interest rates rise it's a basic financial principle that the value of any asset whether it's a stock an apartment building farmland or even a small local business is affected by interest rates what is currently happening though is that the interest rate used to discount those future cash flows is rising resulting in a lower present value for assets that sounds complicated so let me give you an example before we begin please like our video and subscribe to our channel for more content like this let's get started with this video now assume in this example that we are valuing a stock in a company that will operate for 10 years and that we will be able to sell that stock for five times its year time at the end of year 10.
every year of stock yields 10 dollars in cash flow assume the company can increase its annual cash flow per share by two dollars each year for 10 years results in a cash flow of 28 dollars per share to calculate the stock value at the end of year 10 we must discount these cash flows back to the present day using a given interest rate we do this because a dollar received 10 years from now is not worth as much to an investor as a dollar received today in cash i mean which would you prefer a thousand dollars in cash today or a thousand dollars in cash 10 years from now of course you choose the thousand dollars today this idea is also known as the time value of money let's use five percent as our discount rate to calculate the present value of these cash flows we would use the net present value equation to calculate the present value or intrinsic value of this stock which would be 226 dollars and 47 cents so what happens if we change the interest rate at which the cash flows are discounted if we reduce the interest rate to four percent the intrinsic value of the stock rises to 243 dollars and 45 cents if we reduce the interest rate to 3 percent the intrinsic value rises to two hundred and sixty two dollars and nine cents and finally if we reduce the interest rate that those cash flows are being discounted at all the way to two percent the stock's value rises all the way to two hundred and eighty two dollars and fifty eight cents notice how as the interest rate falls by a percentage point the stock's value rises now consider what happens if we reverse the process and raise the interest rate used to discount the stocks cash flows this is an extremely important point to grasp this is what ray dalio is referring to when he talks about the stock market's interest rate adjustment what's happening in the stock market right now is that while interest rates have not risen yet dramatically investors are concerned that they will in the future as a result the stock market has lost value this year it's critical for investors to remember that the value of any stock or any asset for that matter is determined by three major factors how much cash that stock will generate for its investors the timing of those cash flows and the interest rate at which those cash flows are discounted right now investors are increasing the third variable and as a result the stock market's perceived value of stocks is decreasing we'll get into this more later in the video but it's critical to note that ray dalio believes in diversifying one's investment portfolio rather than trying to time the market while you're here why not invest in our channel by giving us a like and a subscription as it'd be highly appreciated now let's return to the video so we have the million dollar question or in ray dalio's case the 150 billion dollar question what should investors do in this market and perhaps more importantly what return should they expect rate value's forecast of three to four percent annual returns for investors is a significant departure from what investors have experienced over the last decade since the great recession investors have routinely enjoyed double-digit annual returns consider the s p 500 indexes returned since 2011.
two percent since 2011 16 in 2012 32 in 2013 14 in 2014 one in 2015 12 in 2016 22 in 2017 negative four in 2018 32 in 2019 18 and 2020 and 29 in 2021. this is a 14.4 compounded annual return on the s p 500 from the beginning of 2011 to the end of 2021 assuming dividends are reinvested this is one of the best performing periods for the s p 500 and one of the greatest bull runs in the u.s stock market history it's a well-known fact that the long-term average return on the u.s stock market is around 10 but what's less well known is that the average return has been far from linear now let's consider the s p 500 in the year 2000 the s p 500 briefly crossed 1500 do you know when it will reach that level again seven years later in 2007 which was a very brief time the aftermath of the great financial crisis and subsequent stock market collapse drove the s p 500 down to less than 800 in 2009 in fact it would take until 2013 for the s p 500 to be comfortably above 1 500 for an extended period of time this means that investors who invested at the peak of the stock market in 2000 did not see a return on their investment until 13 long years later this also means that the annual return for the 13 years invested was 0 excluding dividends if dividends are included the figure is likely to be around 1 to 2 percent in retrospect investors from 2000 to 2013 would have been content with the three to four percent returns ray dalio is mentioning now ray dalio's future return projections become even less exciting when inflation is factored in according to dalio a three to four percent annual return would be just enough to break even after inflation this means that dalio anticipates annual inflation of three to four percent as investors we should be concerned with what is known as our real return simply put this is our return on investment minus the inflation rate during the year assume ray dalio is correct and future returns over the next decade average four percent annually let's also assume dalio is correct about inflation and the average annual rate of inflation is four percent this means that we take our four percent return and subtract the four percent inflation rate yielding a zero percent real return this brings us to the most important topic of this video how can we as investors position our portfolios to generate the highest possible return with the least amount of risk while still mitigating the impacts of inflation ray has two specific pieces of advice to answer this question the first one is to not hoard cash cash as dalio says is trash with the stock market nearing all-time highs it may be tempting to attempt market timing some investors may be tempted to sell their stocks and hold large amounts of cash in order to wait for the stock market to crash and then buy at the bottom however ray dalio has warned that market timing is a fool's game in other words just because the stock market is overvalued doesn't necessarily imply that a crash is imminent indeed dalio has been adamant that holding cash is the worst possible investment the reason for this is because of that pesky word inflation going back to our earlier example of calculating the real return on your investments after inflation let's say stocks return four percent and inflation is four percent which means your real return is zero percent but if you're holding cash your return on cash is zero percent after deducting the four percent inflation rate your real return on cash is negative four percent and a negative real return is only slightly worse than a zero percent real return zalio's next piece of advice is to diversify your portfolio this could honestly be its own video but i wanted to touch on it briefly in this video dalio is a firm believer in portfolio diversification or to use an old adage not putting all of your eggs in one basket this means that investing 90 of your portfolio in tesla stock for example may not be the best strategy instead dalio advises investors to construct a portfolio of investments that will perform well in all types of economic environments while he was constantly watching the market and the economy he himself admits that he can't predict the future and that's all there is to it it's really amazing to learn from an investor like ray dalio and as always thank you for watching before you go please like and subscribe to our channel for more content like this we'll see you soon
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