Sunday, March 05, 2006

Tax, Inflation and Stock Market Returns

Taxes take a good bite out of the investment returns when added into the total return equation. Let’s consider the largest index fund returns for the last 10 years to make a point.

The vanguard 500 index fund (Symbol: VFINX) is the largest index fund and it is also extremely tax efficient. The 10 year before tax annualized return is 9% currently. Vanguard reports that the returns after taxes on distributions was 8.44% annualized for the last 10 years. And here comes the kicker, returns after taxes on distributions and sale of fund shares was 7.67% annualized for the last 10 years.

Now, I am going to add inflation to the equation. I would like to use 4% annual inflation rate instead of the government reported 3% rate because there is a widespread belief in the sane investment community that the real inflation is close to 4%, if not higher.

Subtract 4% from the 7.67% and you are left with 3.67% real return from your index fund investment. Even if you use the government reported data and subtract only 3% for inflation, the real return stands at 4.67%.

Most of the money invested today does not go to the index funds. Actively managed funds are in business and collectively tend to lag the market by 2%. Those funds leave investors with zero to close to zero gain when Uncle Sam collects and inflation takes its toll.

4 comments:

Jose Anes said...

Precisely the reason that most people suggest that money invested in an SP500 index fund allows you to take 4% out per year, while still conserving its original value -- after taxes and inflation.

If you want 4,000 a year out of an SP500 based account, you need to put $100,000 on it.
If you want an income of $40,000 a year (will adjust for inflation, don't worry), you need a $1,000,000 of today's money.

That is also why most people want a million. You can live on a million -- as the average american family lives on a $40,000 a year income.

Money And Investing

Loi Tran said...

4 percent real returns is not bad. A lot of people think the market will return less than that in the future. Only time will tell.

Suresh said...

Retail investors like ourselves cannot hear this message enough!

Now, additionally take into account investment expenses. Consider Thornburg Investments' article entitled, Study of Real Real Returns, at http://www.thornburginvestments.com/research/articles/real_real_0705.asp.

How serious should we take investment expenses? Consider Warren Buffett's parable on frictional costs in his latest letter to Berkshire shareholders? An excerpt can be found at http://www.incometrap.com/forum/viewtopic.php?t=739

Generating replacement income from one's assets is no walk in the park The Thornburg article, for example, clearly suggests how important early and/or large regular investments are.

air compressors said...

How does a fund make 9% and be a low-tax investment. U.S. debt pays no where near 9%. Also I think a lot of people really want to be richer, not just keep up with inflation. Income per capita usually grows around 2.5 to 3% higher than inflation. So if you want to stay as rich as the next guy to need to grow your net worth about 6% a year.