Financial FitnessGeneral Information

What is the Real Rate of Return and why should you care?

By August 15, 2019 No Comments

Today I would like to share a concept with you called Real Rate of Return

I think it is important to know what your overall return on your portfolio is, but it is also important to know what your Real Rate of Return is.

What is the Real Rate of Return?

According to Investopedia, Real Rate of Return is the annual percentage return on an investment or portfolio and is adjusted for inflation.

For example, if a portfolio had a return of 5% over the last 12 months and inflation is about 2%, the real rate of return is then 3%.

If the portfolio is in a non-retirement account, we often look at what the after-tax real rate of return is.

Assuming a 25% federal tax bracket and a 5% state bracket, or a 30% tax bracket combined, that same 5% portfolio return from the above example, after we take 30% for taxes, leaves us at 3.5% with an after-tax return.  And when we factor in inflation, the after-tax real rate of return is only 1.5%.

Why is that important?

According to the Department of Labor, when we look at inflation as measured by the Consumer Price Index, inflation was up 2.2% annually for the last 25 years, from 1994 to 2019.

However, if we look over the previous 50 years from 1944 to 1993 inflation averaged 4.3% annually, so obviously the last 25 years inflation has been significantly lower than the previous 25 years.

In summary, it’s not only important to look at your overall portfolio return, but to look at the real rate of return because inflation is ultimately what can erode your overall purchasing power.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  All performance referenced is historical and is no guarantee of future results.  All indices are unmanaged and may not be invested into directly. 

The example provided is hypothetical and not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.