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Are your investment returns real?

November 13, 2010 Leave a comment Go to comments

This post isn’t about paper gains or ponzi schemes – it’s about real real returns. A huge mistake many uninformed investors and their advisers make is not using real returns when looking at the future. And it gets even worse when they expect unrealistic long-term returns on top of that.

This might seem crazy – after all, most people just throw around nominal returns all the time and it’s true that when you’re comparing one investment to another the 2% difference is mostly the same whether it’s real or not. Adding to that, no one can know future inflation any more than they can know what the performance of the stock market will be.

There is one big reason you need to work with real returns though – everyone has to live with inflation. It doesn’t matter what numbers you type into a spreadsheet today, $1000 in 40 years will be worth less than $1000 today. Not only that, but the assets you have at that point in time won’t change based on the type of calculations you do (unless you make different investment decisions based on the results).

Real returns make your plans safer. If you plan to spend nominal returns it’s virtually guaranteed that you will be disappointed in the future. If you calculate real returns you’re more likely to actually get what you expected, and you’re also more likely to get more than you expected. I’ve learned from running a business that good surprises are always more pleasant than bad surprises, and safe plans that make you work a little harder but usually work out in the end are the best way to go.

Estimates will be wrong – but if they’re reasonable, and they’re over a long enough time period, they can be better than giving up and saying “who knows what will happen”. It’s true that many people don’t know how to estimate inflation and may go in the wrong direction so you need to find a reference that works for you. But at its simplest this can come down to working with the long-run real return instead of looking at nominal dollars.

After all, given enough time other investors will adjust to inflation and performance will vary accordingly; a profitable company selling a good product will increase nominal profits as inflation rises, so the long-run real return is likely to be a more stable and consistent measure than the nominal stock price increase.

You don’t necessarily need to estimate inflation year by year. Some investors choose to calculate the real returns in one big step – adjusting their estimated assets in 40 years for 40 years of inflation. This is fine too; either way you need to make sure that your plans are based around something you can “realistically” expect to get – hence the “real” returns 🙂

All my projections are based on real returns, since that’s all I expect to have in the end. In the short term this does depend on whether we’re likely to be in a higher- or lower-inflation environment, while long-term projections can be simpler to do by simply adding up average real returns over that time period (ie 5% real return for 20 years = a 165% gain).

Taxes are important too – after all most investments can’t be used without paying the tax first. Right now I still have enough TFSA and RRSP room to be fairly flexible with taxes, but I do need to account for the taxes on income generated from RRSPs. For other investors this may be a bigger concern if they have a substantial unregistered portfolio and it has to be calculated correctly to know what you’ll actually get.

Are any parts of your investment plans based around nominal rather than real returns? What can you do starting now to make sure that everything you have planned is real?

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