EVEN IF WE CLOCK INVESTMENT GAINS, we may not be making any financial progress if our investment gains aren’t outpacing the twin threats of inflation and taxes. For instance, if we earn 3% this year but inflation is running at 5%, we’re losing money—and the loss would be even greater once we factor in taxes.
In the previous section, we saw that a 5% investment loss was more damaging than 5% inflation. Earlier, we also saw that the punishment from a 25% investment loss was greater than the benefit from a 25% investment gain.
That leaves one last comparison: How does the damage from inflation compare to the benefit of an investment gain? If we gain 5% in a year, we multiply our portfolio’s value by 1.05. Meanwhile, if we want to know the loss of purchasing power from 5% inflation, we would multiply our portfolio’s value by 0.952 (the product of 1/1.05). So what if we have a year with both a 5% investment gain and 5% inflation? We would do this calculation:
1.05 x (1/1.05) = 1
In other words, the damage from 5% inflation is equal to the benefit from a 5% investment gain. For rough calculation purposes, investors sometimes subtract the inflation rate from their nominal (before inflation) gain to get their real (after inflation) gain. This produces an accurate result when both are the same—but not otherwise.
Let’s say you have a 10% nominal gain and inflation is running at 4%. If you simply subtract the 4% inflation from your 10% nominal return, you get a 6% real return. But to get a more accurate answer, you would need to do this calculation:
1.1 x (1/1.04) = 1.0577
Thus, the real return is 5.8%.
Next: Total Return