Investing can be a fun enterprise when your investments are increasing in value. Like gambling wins, people love to talk about their successful investments.
But most people do not accurately compute their investment returns. They almost always get the initial computation correct – a $2 gain on a $10 investment produces a 20% return. That’s true, but it also ignores two very important considerations.
Investors must never forget about taxes and inflation. Rarely are those two factors properly considered. But they are hugely important.
The reason why can be illustrated with two investors.
Let’s say Investor One buys stocks for $100,000 and sells them just less than a year later for $120,000. Investor One is ecstatic. He just made $20,000, an impressive 20% return. Or did he?
First, taxes will be due on the investment gains. Even worse, since Investor One didn’t hold the investment for more than one year, his gains are taxed as ordinary income. Let’s say between federal and state taxes, that rate is 30%.
So, $6,000 of Investor One’s $20,000 return is swept away in taxes. That leaves him with $14,000.
But we also must account for inflation. Why? Because if inflation is roaring, then Investor One’s purchasing power would have been eroded over the year that he held the investment. And purchasing power is what we are really interested in growing over time, not just dollars.
Let’s say inflation is galloping at 9.5% a year, similar to what we have seen recently in the economy. That means Investor One’s initial investment of $100,000 now purchases $9,500 less than it did one year prior. That’s why inflation is considered a silent tax. Unlike actual taxes, which are paid to taxing authorities, inflation swindles you far more discretely. You don’t notice it until you go to buy something and that thing now costs more than it did a month ago or a year ago.
So, $9,500 represents a loss of purchasing power. That amount should be deducted from Investor One’s gains to get a true sense of his real return. And make no mistake, real returns are the only returns that matter.
That leaves Investor One with $4,500 after taxes and inflation, a 4.5% real return. Not bad, but it’s a far cry from the initial return calculation of 20%.
After hearing of Investor One’s 20% return, Investor Two decides a year later to make her own investment.
Investor Two buys stocks for $100,000 and sells them just over a year later for $109,000. She made $9,000, a respectable 9% return. But she was bummed. Her return was not nearly as good as Investor One’s return. In fact, it was less than half the return. But let’s calculate the real return.
Again, taxes will be due on the gains. Fortunately, since Investor Two held the investments for more than one year, her $9,000 gain is taxed at capital gains rates, not ordinary income tax rates. There’s a big difference. While ordinary income taxes may be 30%, capital gains taxes would be more like 18%.
So, $1,620 of Investor Two’s $9,000 gain is swept away in taxes. That leaves her with $7,380.
Again, we also must account for inflation, though. Let’s say inflation for Investor Two was more like 2.5%, which has been typical over the last few decades in the economy. That means her initial investment of $100,000 now purchases $2,500 less than it did one year prior. That must be deducted from her investment gains.
That leaves Investor Two with 4,880 after taxes and inflation, a 4.9% real return, and about $380 more than Investor One.
Look at that.
Even though Investor Two earned less than half the return of Investor One, she ended up with a better real return. Returns that appear impressive initially can be quickly humbled when taxes and inflation are accounted for properly.
That’s why when it comes to investments, it’s important to always get real with your returns.
Justin Lueger is President of Invisor Financial LLC, a registered investor adviser firm in the State of Kansas. All opinions expressed are his own and should not be viewed as individual advice. He can be reached at firstname.lastname@example.org.