Want to know what return you might expect before you invest?
October 5, 2015 Hengehold Capital Management, Cincinnati OH
Understanding the difference between nominal and real return on investments
If you're like most people, you probably want to know what return you might expect before you invest. But to translate a given rate of return into actual income or growth potential, you'll need to understand the difference between nominal return and real return, and how that difference can affect your ability to target financial goals.
Let's say you have a certificate of deposit (CD) that's about to expire. The yield on the new three-year CD you're considering is 1.5%.
But that 1.5% is the CD's nominal rate of return; it doesn't account for inflation or taxes. If you're taxed at the 28% federal income tax rate, roughly 0.42% of that 1.5% will be gobbled up by federal taxes on the interest. Okay, you say, that still leaves an interest rate of 1.08%; at least you're earning something.
However, you also need to consider the purchasing power of the interest that the CD pays. Even though inflation is relatively low today, it can still affect your purchasing power, especially over time. Let's say that consumer prices have gone up by 1% over the past year and you adjust your 1.08% after-tax return for inflation. Suddenly, you're barely breaking even on your investment.
What's left after the impact of inflation and taxes is your real return, because that's what you're really earning in actual purchasing power. If the nominal return on an investment is low enough, the real return can actually be negative, depending on your tax bracket and the inflation rate over time. Though this hypothetical example doesn't represent the performance of any actual investment, it illustrates the importance of understanding what you're really earning.
Knowing the difference between nominal and real return may help you make better decisions when it comes to investing your money. Understanding this difference, Hengehold Capital Management invests in a diversified portfolio of both equities, which have outpaced the rate of inflation over market cycles, as well as fixed income securities which help provide consistent cash flow.
We complement your investment allocation with proper asset location, which helps reduce the tax-drag on your investment returns. If you have a question about your allocation or asset location, please talk to your financial advisor.
Source: American Institute of CPAs (AICPA) Broadridge, September 2013
Content in this article is not intended to be financial advice. Instead, we think of it as educational, and financial education is important to us.