Do You Know the Real Rate of Return On Your Investments?

Do You Know the Real Rate of Return On Your Investments?

Many investors look at their monthly statements or review their account online and look at a couple of numbers to determine how their investments are doing. The first number is usually the balance in your account. If it is more than it was the last time you looked at it then you feel good. Next they look at the percentage return on their portfolio to see if it is a number they can feel good about. Obviously, the higher the number the better. However, before you put your statement away it is important for you to understand what your rate of return is really telling you.

In August 2014 Thornburg Investment Management authored a study on investment returns and what the real rate of return is on a portfolio. You can review the study by clicking here. Thornburg notes that nominal returns are a misleading indicator of what the returns on your portfolio actually mean in terms of the buying power of your money. Different investment vehicles offer different potential for real rates of return. The big question is; how should you invest your hard earned dollars to give you the best buying power when you need the money?

In order to determine the Real Real Rate of Return you need to consider not only the interest rate or market growth of your invested dollars but also the erosion of the nominal return from taxes, expenses and inflation.

Let’s take a couple of examples of different investments and compare the effect of these additional components on your return. The first example assumes a $100,000 one year certificate of deposit (CD) at a bank. Today a typical rate for a one year CD is 1.50%. The second example is a diversified portfolio of investments consisting of 50% bonds and 50% stock funds with an average return of 8.3% over the past 10 years. Of course, these returns are for illustrative purposes only and the return you would receive may vary significantly from these examples. The charts show how these would stack up.

1 Year CD at 1.5% Interest Rate
Initial Deposit $100,000.00
Interest Earned $     1,500.00
Total Balance at Maturity $101,500.00
Taxes * $      (330.00)
Inflation ** $   (1,928.50)
Buying Power of Investment $  99,241.50
Real Real Rate of Return -.76%
*assumes 22% marginal tax bracket

**assumes 2018 inflation rate of 1.9%

 

Balanced Investment Portfolio
Initial Deposit $100,000.00
Investment Growth at 8.3%* $     8,300.00
Total Balance at Maturity $108,300.00
Portfolio fund expenses at .55%** $      (595.65)
Taxes *** $    (1,826.00)
Inflation **** $   (2,057.70)
Buying Power of Investment $103,820.65
Real Real Rate of Return 3.82%
*assumes average growth rate of balanced portfolio over past 10 years

**assumes 22% marginal tax bracket

**assumes 2018 inflation rate of 1.9%

This is a very simplistic overview of the effects of taxes, expenses, and inflation on returns. In reality you may also have dividend taxes and if you hold your investments more than one year you would pay long-term capital gains taxes in place of short-term gain taxes. However, you can see that the CD produces a negative real return in buying power where the balanced investment portfolio produces a positive return. Although you have a higher tax obligation and expenses associated with the investment portfolio you still end up with more money, even net of inflation, with the investment program. Risk is always a factor in your investment decision and there is inherently greater market risk with the investment portfolio. However, knowing that you have a better chance of ending up with more money and greater buying power can help offset some of the risk.

Before making any decisions on where to invest be sure to consult a professional. If you would like to learn more about the real return, contact us and we will be happy to schedule a time to review your situation with you.

 

Written by:  Dennis Kelley, Managing Partner

 

These are the opinions of Dennis Kelley and not necessarily those of Cambridge, are for information purposes only, and should not be construed or acted upon as individualized investment advice.  Investing involves risk.  Depending on the types of investments, there may be varying degrees of risk.  Investors should be prepared to bear loss, including total loss of principal.  The strategies discussed herein are not designed based on the individual needs of any one specific client or investor.  In other words, it is not a customized strategy designed on the specific financial circumstances of the client.  However, prior to opening an account, Cambridge will consult with you to determine if your financial objectives are appropriate for investing in the model.  You are also provided the opportunity to place reasonable restrictions on the securities held in your account.