Be happy you don't live in Zimbabwe. The nation sports not only a very low life expectancy, in the 30s, but also runaway inflation on the order of 15,000% per year. What does inflation like that really look like? Well, a package of six sausages reportedly increased in price thirtyfold recently, just over a single month. That rate would turn a $5 purchase into a $150 one. Just try to imagine a $150 package of hot dogs. And the following month, it might cost $4,500, followed by $135,000 the next month. People actually face these conditions.
We Americans can hope to avoid such inflation rates in our lives. Our rate has sometimes risen, and sometimes fallen, but has averaged in the 3% to 4% range most of the time. Still, we need to keep even those low levels of inflation in mind when we think about our investments.
Your real return
How should you account for inflation in evaluating your portfolio's returns? Well, consider this example. Let's say you buy $5,000 worth of stock in Scruffy's Chicken Shack (ticker: BUKBUK) and sell it almost a year later for $5,800. Your total return is 16% ($800 divided by $5,000). Many times, we stop there with our number-crunching. But if you want to get a more realistic number, there are a few more factors to consider.
First up is the tax man. Let's say that your tax bracket is 28%. This means you fork over 28% of that $800 profit to Uncle Sam for short-term capital gains, while you keep 72%, or $576. That cuts your 16% return to an after-tax return of 11.52%. For investors in higher brackets, the effects can be even more profound. (Next time a friend who invests money for the short term tells you his or her returns, ask about that friend's tax bracket. It might look like he or she is earning a higher return than you are -- until you figure in taxes. And commissions.) One way to reduce the tax bite is to hold stocks longer than one year to qualify for long-term capital gains tax rates, which currently top out at 15% for most folks -- but even so, that's 15% less profit.
Next up, Old Man Inflation. Money is worth less as time marches on and prices rise. While your investment grows and takes two or three steps forward each year, inflation pushes it one step back. Let's say inflation was 2.5% during the year of your investment. That means the $5,576 you have after taxes has the purchasing power of only $5,440, yielding an after-tax, inflation-adjusted return of 8.8%. And that's with a stock with a healthy return. With lower-yielding investments like money market funds, this effect can wipe out most or all of your gains.
For returns covering multiple years, you take the annualized after-tax return and subtract the annual rate of inflation during the period. You can get more information on inflation (as measured by the Consumer Price Index) from our friends at the Bureau of Labor Statistics. Check out their nifty inflation calculator!
The bottom line
Just remember that inflation matters. For example, if you're planning to buy a fixed annuity that will pay you a set amount annually for the rest of your life, consider inflation. If you're still in your 50s, you may have another 40 years of life ahead of you. A fixed annual income of $50,000 may seem reasonable today, but if inflation averages 3% over the next 20 years, it will make that $50,000 worth about $27,600 when you still face a few more decades of life. So consider getting an annuity that's adjusted for inflation.
