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 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?