Wednesday, June 21, 2006

Breakeven Point Before Real Returns

What is the break-even point before you get a real return?

Let's examine.

Consider an investment that returns 5% nominally, that is, the return before taxes and inflation is 5% (like bonds, bank CDs, money market funds, online savings accouts like ING direct, Emigrant direct type of investments). Also assume that you are in 25% federal tax bracket and your state and local taxes are about 5%. The total taxes on the investment return are 30%. The 5% investment return gets trimmed down to 3.5% after tax is taken into the consideration.

We know that the inflation has averaged between 3%-3.5% for the last 50+ years. If you are like me and believe that the Government is low-balling the inflation numbers, you put the inflation average in the 3.5%-4% range. Taking the lower number in this range and subtracting 3.5% from our after tax return of 3.5% leaves you with nothing.

Of course, the income from the tax-exempt bonds or dividend payments from stocks are taxed at lower rates than other income instruments, but the impact of inflation is felt across the board.

After taxes and inflation, a 5% nominal return becomes 0% real return. A 5% nominal return is a break-even point.

If you earn less than 5% return on your investments, then you are in fact losing money, in real terms.

1 comment:

Suresh said...

I'm with you Moneywise in thinking that the BLS' inflation rates are cooked. John Williams' analysis at http://www.gillespieresearch.com/cgi-bin/bgn correctly notes the effect of substitution, hedonics, and geometric weighting in holding inflation expectations in check. Indeed, he estimates that the CPI, if calculated according to pre-Clinton administration formulas, would be above 7% per year.

So, getting back to your analysis, consider the yield on a 10 year Treasury bond of around 5.22% in nominal terms. Applying Mr. Williams' CPI figure, an investor of a 10-year bond could lose around 2%/year in real terms. How is that for a risk-free investment?