Thursday, January 27, 2005

Are Your Returns "Real"?

When investors, wall street, and the media talk about the returns of different investments they are usually talking about "Nominal" returns. The term nominal refers to the actual return of an investment including the return generated solely by inflation (which really isn't a return at all). What does this mean in plain english? The nominal return is the return you see, but not the return you get to spend. Most investors have no idea that they should be focusing not on "nominal" but on "real" returns. A "real" return is simply the rate of return you earn on an investment after subtracting inflation. Let me give you an example.

Let's say you that on January 1, 2005 you put $1,000 into an investment with the intent of selling that investment in one year (January 1st, 2006). Your intent is to purchase an item that on January 1st, 2005 cost $1,000. During the year you earn a total return (nominal) of 6% and end up with $1,060 (ignore taxes for now). If the item you planned on purchasing with this money will now cost you $1,070 have you actually earned anything with your money? The answer is no. Even though your money earned 6% during the year, the prices of the items you want (and presumably need) to purchase rose by 7% during that same time period. Your investment return didn't keep up with inflation. Even though 6% seems like a good rate of return, in reality your "real" rate of return (Return after inflation) was -1%. You actually lost purchasing power, your actual return, the return you can spend was negative.

As an investor your pursuits should focus not on the returns that you can see, but the returns that you can spend. Over the long run you want to invest with the goal of earning a "real" return. You want your money to grow faster than that of inflation so that your money can buy at least the same or more than when you started to invest it.

You often hear in the press that stocks have historically earned about 10%, however that shouldn't mean anything to you. What you should really be asking is what did stocks (or bonds) return after inflation is taken out, what is my "real" return. Long term the "real" return of stocks has been about 6.5%. The next question that must be posed is whether or not going forward we can expect to continue to earn 6.5% above inflation from holding stocks. My instinct is that it is a possibility, but unlikely. My next column will focus on what return we should expect in the years ahead from different asset classes.

Until next time..........