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Real Rate of Return


I have always tended to lean toward equities but the increase in interest rates certainly presents an alternative case (or so it seems).

 

The phrase is “real rate of return” that we are getting where none existed during times of 0% interest rates. The basic calculation for the real rate of return is the nominal rate minus the inflation rate. 

 

As a basic example let’s use 5% interest on a bank CD. From this we subtract the current 3.2% inflation rate and, voila, there is a “real rate of return” of 1.8%. Maybe not awesome but good enough for safe money.

 

But here’s the real calculation because taxes exist. And in the case of this example, taxes are paid on the entire 5%, not just the real rate of 1.8%.

 

So, let’s do the calculation again assuming a 25% effective rate.  5% minus a 25% tax gives us a net of 3.75%. Now the inflation rate can be deducted (3.75%-3.2%) and the NET is now .55%. In fact, if we assume a combined effective rate of 35% between federal and state taxes, we pretty much eliminate any “real rate of return” on this bank CD.

 

Now there is no comparison between a bank CD and equities from a behavioral standpoint. Annually the variability of returns in the stock market is much greater (and poses more risk) than a bank CD so it is still a preferred vehicle for safe money. 

 

My point is a bit more nuanced. Market risk with equities absolutely exists but so does “purchase power” risk. This is the risk associated with having your money grow fast enough to keep up with inflation. 

 

While fixed income, in most cases, is a way to earn some return and reduce market volatility it may not offer the ability to take on the long-term inflation monster that exists over time.

 

Just simply make sure you balance your needs for safety with your needs to keep up with inflation because there are risks on both sides of the equation.


The opinions expressed in this commentary are those of the author and may not necessarily reflect those held Twin Gryphon Advisors, LLC. This is for general information only and is not intended to provide specific investment advice or recommendations for any individual. It is suggested that you consult your financial professional, attorney, or tax advisor with regard to your individual situation. Comments concerning the past performance are not intended to be forward-looking and should not be viewed as an indication of future results. 

Investment advisory services offered through Twin Gryphon Advisors, LLC, a registered investment advisor. 

The material is for informational purposes only. It represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results. It does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Neither the information presented, nor any opinion expressed, constitutes a solicitation for the purchase or sale of any security. 

Past performance does not guarantee future results. 

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