Many investors focus on nominal return or the percentage increase or decrease in the value of an investment over a given period of time. Usually, this is expressed as an annual return. Total return factors interest payments and dividends as well as percent change in the value of the investment.
However, investors hoping to achieve financial goals need to take more than total return into account. Your real return is the amount your investments return after taking taxes and inflation into account.
Real return in action
Let’s say you want to purchase a bank-issued certificate of deposit (CD) because you like the lower risk and fixed interest rate that a CD can offer. You might purchase a two-year CD that offers that pays 3% interest.
Now say you pay 22% in federal income taxes—roughly 0.66% of that return goes to tax payments. That means the CD yields closer to 2.34%. Now, account for inflation, which ranges from 2-3% per year on average. Your real return is now close to zero, you’re simply keeping up with inflation.
This hypothetical example doesn’t represent the performance of any specific investment, but it illustrates the importance of understanding what you’re actually earning after taxes and inflation.
In some cases, taking on less investment (or market) risk can open your portfolio up to other types of risk, like inflation risk. Pursuing long-term goals, including retirement, depends on your real returns rather than nominal or total returns. A financial advisor can help you look at your portfolio performance with taxes and inflation in mind.
To discuss how your portfolio’s real returns and risk profile lines up with your investment goals, schedule a call with a Bogart Wealth expert.
