By Kris Sayce, editor, Casey Daily Dispatch
Investing can be dangerous.
Not in a life-or-death kind of way.
But it can make or break your standard of living.
Whether you get to enjoy retirement.
Or whether you’re stuck counting pennies…
And checking vending machines for others’ forgotten change.
So how can you make sure you get it right?
A big part of it is understanding your true investment returns.
Sounds easy. But many investors get it completely wrong…
If this is your first time reading the Dispatch, welcome. If you’ve been here before, welcome back.
At the Dispatch we have two goals:
To introduce you to the most important investing themes of the day, and
To show you how to profit from them.
We do this by showcasing ideas from our in-house investing experts, Dave Forest and John Pangere. And from the founder of our business, Doug Casey.
Today, we’ll continue with the subject we began yesterday: the miscalculation of returns and the harm it can do to your investments… and your future.
Let’s keep this simple.
If you have all your investments in stocks, and your stocks gain 10% in a year, what’s your annual return?
If you make 10% in the first year and 10% in the second year, what’s your annual return?
That’s right, still 10%.
And if you make a 10% return each year for three years, your annual return is…
See, we said this was easy.
However, while that may be your annual return, that doesn’t necessarily make it your real annual return.
To work out your real return, you need to account for inflation. That’s because inflation has a big effect on your returns, and therefore on your future lifestyle.
[Editor’s note: We’re keeping this simple, so we won’t factor in transaction costs or taxes.]
Let’s assume inflation is 2% for each of those three years. What’s your annual return?
Again, simple. You need to subtract the 2% inflation rate from your 10% return. That means your real return is 8% per year.
When we look at short timeframes, it doesn’t seem like a big deal. But when you look at the longer term, you see the massive difference.
Check out the following tables. Here’s our first example, where we assume no inflation:
After three years, with an annual return of 10%, your portfolio will be worth $133,100.
After 15 years, it’ll be worth $417,725. And after 30 years, it’ll be worth over $1.7 million.
How Inflation REALLY Hurts Investors
Now take the same starting pot… and the same annual return… but include a 2% inflation rate. Remember, this is the rate governments, central banks, and mainstream economists insist is a “normal,” or even “desirable,” inflation rate.
This table shows your real return after inflation’s effects.
Instead of your investments being worth $133,100 after three years, the real, inflation-adjusted value is just $125,971. After 15 years, instead of your investments being worth over $417,000, the real value is just over $317,000.
And after 30 years, instead of your investments being worth $1.7 million, your after-inflation return is a touch above $1 million.
In other words, after 30 years, even a “desirable” 2% inflation rate costs you over $700,000 in purchasing power.
But what if we use today’s 6.2% inflation rate… but only for the first two years? After that, we’ll return the inflation rate to a lower 2%.
Here’s what happens (we’ll use 6% to make it easier):
Now, instead of your investments being worth $125,971 with a “healthy” 2% inflation rate, they’re worth just $116,813 after three years.
They’re worth $294,155 after 15 years…
And after 30 years, they’re worth $933,108.
You can see the difference. It only takes two years of “above normal” inflation for it to knock $73,000 from your retirement savings over 30 years. That’s no small sum.
Imagine if the inflation rate were higher… or it lasted longer. The story would be even worse.
(Just note: In these tables, we’re showing you the equivalent value in today’s dollars. Your portfolio would still have the nominal value of $1.7 million in 30 years, but it would be worth only the equivalent of just over $1 million or just over $933,000 today, depending on the scenario.)
That’s the real cruelty of inflation. It’s hard to notice it. If you’re not careful, you’ll notice it only in the future… when your standard of living is a lot lower than you expected.
It’s Potentially Much Worse
Consider a higher inflation rate. Many folks believe the government underplays the true rate. That the true inflation rate could be double the official rate.
But let’s be conservative. Let’s say the inflation rate is 3% over the next 30 years. Just that seemingly small increase would have a big effect.
Instead of a net real portfolio value of just over $1 million after 30 years with 2% inflation, your real portfolio value with 3% inflation falls to just $761,226.
That means that in this example, inflation has cost the investor more than $200,000 in lost returns compared to a 2% inflation environment. And it’s cost the investor nearly $1 million in lost returns compared to a no-inflation environment.
The fact is… the difference between $1.74 million and $761,226 is staggering.
How would you feel if your portfolio value dropped by 56% – more than one half – over the next 30 years due to inflation?
That’s like a 2008-2009 plunge.
Many investors don’t understand or consider inflation. So they don’t understand the effect it has on their real portfolio values.
That means they don’t understand what they need to make on their investments to achieve their desired standards of living.
But there’s a solution…
It Requires Change, But It’s Achievable
The first part of the solution is to make sure you understand this is happening.
The second part is to do one of two things.
One option is to acknowledge that inflation will reduce the real value of your returns over time, keep your portfolio as it is, and adjust your lifestyle projection to a lower standard of living.
The other option is to understand the effects of inflation and adjust your investment portfolio. That means aiming for higher returns… and maintaining your lifestyle projection.
The important thing is, if you go for the second option, you don’t have to change your whole portfolio.
In fact, it’s possible to make relatively small changes to achieve the outcome you’re after… and combat the cruel effects of inflation.
Editor, Casey Daily Dispatch
P.S. An easy way to combat inflation is by doing better in your investments. That’s where colleague Dave Forest’s warrants plays can help you close the wealth gap inflation is creating.
Just go right here to learn how you can make triple- and quadruple-digit gains.