Wednesday, July 13, 2011
How much did your investments really earn last year? You can calculate a rate of return with simple math (don't forget dividends if any), but if you don't adjust it for inflation and taxes, you're not getting the real rate of return.
This is the difference between the nominal interest rate and the real interest rate. You want to know the real rate, since that is the only number that means anything.
Think of it this way: the nominal interest rate tells you the growth rate of your money, while the real interest rate tells you how much your purchasing power is growing.
For example, if you make a Rs. 1,000 investment that earns 8% in one year, you end the year with Rs. 1,080. In other words, your money has grown by Rs. 80 (we'll assume no dividends just to keep the illustration simple).
However if inflation is 3% for the year, your Rs. 1,080 is only worth about Rs. 1,050. Inflation devalues not only the interest you earned, but the principal too. Your real rate of return is only 5%.
Investors depending on dividend income or interest from bonds or other fixed-income securities are most directly affected by the costs of inflation.
If you hold a stock, the gains build up until you sell, so it may be possible to avoid the "inflation tax" if you can time the sale for periods of low inflation.
Stocks can generally weather the effects of inflation better than bonds or other savings instruments. Companies can pass on the higher costs of inflation to customers. Of course, this tends to keep the inflationary cycle going.
The above exercise adjusted your rate of return for inflation; however, it was purely academic unless your investment was in a tax-deferred account or a tax-free investment.
The other deduction you need to take to reach the real rate of return is for taxes. You don't get to keep - in most cases - all the money you make. The government will want its share too.
Let's return to our example. You invested Rs. 1,000 and earned 8% nominal return for Rs. 1,080. However, inflation is running 3%, so your real rate of return is only 5% giving you purchasing power of Rs. 1,050.
Even though your Rs. 1,080 will only buy what Rs. 1,050 would one year ago, you still have Rs. 1,080 in your account and the government wants a piece. For simplicity sake, let's assume that taxes totaled 20% in your bracket and that this qualifies as a long-term gain.
The government will want Rs. 16 of your Rs. 80 gain in taxes. Now your real bank account is down to Rs. 1,064.
If we reapply the 4% inflation to what you will actually get to keep, we will come up with the real purchasing power your investment returned. This figure is Rs. 1,021 (96% of Rs. 1,064 = Rs. 1,021).
The ugly bottom line is this. Your Rs. 1,000 investment has bought you a real return of 2.1% increase in purchasing power over last year after taxes.
That doesn't sound like much, however if you run all investments through the same exercise, you'll find similar results.
Real returns don't sound as good as nominal rates of return, but they are the truth and not an illusion.
Returns Should Account For Taxes & Inflation