The importance of real returns
When looking at performance from our investments, we invariably miss to include an important piece of information.
Inflation
We don’t regularly adjust rates of return for inflation, using what is known as the real rate. Every investment return should be expressed in real terms, because it reflects the true purchasing power of money. Even with inflation as low as 2.5%, $100 today will need to grow to $102.50 to buy the same basket of goods in a year.
If your money is in a term deposit earning 2% a year, it’s a negative yield in real terms.
Many people proudly boast of the increase in the value of their house or investment property. Let’s say you bought an apartment for $500,000 in 1998, or 20 years ago. Average inflation of 2.6% compounded over 20 years reaches $840,000. Okay, property prices have done well in the last five years, but not only must you adjust for legal fees, stamp duty, maintenance and renovations, but the real price is 68% higher or $340,000 more than you paid.
While it might sound good to say you doubled your money if you sold the apartment for a million dollars, it’s likely you earned little in real terms (of course, there are many other factors such as rent and loan payments to consider in calculating the total real return).
Are we close to an Australian sharemarket all-time high?
The All Ordinaries Index is currently (on 18 June 2019) about 6,650. The all-time high for the index is 6,873 in October 2007, before the GFC. It then fell precipitously to a low of 3,112 in March 2009, a period that destroyed the wealth of many Australians. Over the past decade, the market has clawed its way back, with a strong first half of 2019 so far.
But the All Ordinaries is a price index, similar to the price of apples or bananas. To measure the all-time high in real terms, the 2007 level should be adjusted for inflation.
Thus, 6,873 in October 2007 is about 8,800 in real terms.
What is your next step?
Inflation is the missing link to properly evaluating the return on your investment over time.
Keeping a watch on asset classes (real estate and bond markets), that traditionally thrive when inflation spikes, may just put you in the winner’s seat.
Source:
Graham Hand – Managing Editor of Cuffelinks
Investopedia
