We bought our first house in 1982 and were happy to take out a mortgage at 11% interest. This year new mortgages were issued with an interest rate of up to 15%. It’s hard to remember such high interest rates, but 1982 wasn’t that long ago. Around the same time, I bought a bond on my IRA account that paid about 7% interest annually for five years and thought I had done very well.
But had I done really well? Not really – although the bond paid a “nominal” return of 7% every year, my “real” return was far worse. Inflation fell in 1982 but averaged 4% a year for the five years I owned the bond. Subtract that 4% from my 7% return and I had a 3% return (the “real” return) after inflation.
But wait, it’s getting worse. Our tax bracket in 1982 was around 25%, which of course was applied to the total 7% return on the bond. This tax “costs” 1.75% of the return (7% x 0.25), so we get a “real return” on our wonderful bond of 1.25% per year. So our “7%” loan actually paid us little more than 1% a year, which really mattered – an increase in purchasing power over time.
At least it was a positive “real” return. Many investors lose purchasing power year after year in times of higher inflation because inflation and taxes are twice as high. Indeed, this is the norm for assets like cash and CDs, especially when interest rates are kept low by the Federal Reserve. Look at the past 10 years for a great example. A one-year taxable CD from a bank (let alone a money market fund that pays significantly less than 1% per year) was likely paying an average interest rate of 1% over this period. Subtract taxes and apply the average inflation rate of around 2%. They have lost purchasing power year after year. Even with the recent rise in short-term interest rates to around 2%, your “real return” after tax and inflation is negative.
So what counts with our investments is the “real returns”, not the advertised return on a bond or the return on a mutual fund investment. Historically, cash and short-term fixed income investments (like bank CDs) have had almost no real return (and negative real return over the past 10 years, as we have already noted). Longer-term fixed-income securities historically achieve a real return of 2-3% per year, but even in the past 10 years have at best broken even. The only asset class that has had long-term real return for many decades is the stock market. Depending on which stock exchange class you invest in (small company, large company, domestic, international, etc.), you have generally achieved a real return of 3-6% per year, averaged over many decades of investment.
Think about why we invest in the first place. It’s about at least maintaining the ability to buy the same amount of “things” with our money in the future. Even better, in exchange for the risk of borrowing money (fixed income) or owning stocks of companies (stocks), we should hope to slowly increase how much we can buy with any given investment in the future.
So get real when you think about growing your money. Before you decide to invest your hard-earned funds, consider taxes and inflation.
Dr. Steven Podnos, CFP®, is a paid financial planner based in Central Florida. He can be reached at [email protected] and at www.WealthCareLLC.com.