It's worth taking inflation into account when you estimate returns on your money. After all, inflation has a powerful effect on your wealth. Let's run through an example.
If Marge buys $5,000 worth of stock in Las Vegas Light & Power (ticker: GLITZ) and sells it almost a year later for $5,800, her total return is 16% ($5,800 divided by $5,000 equals 1.16, revealing a 16% gain). Many times we stop there in our number crunching. But, if you want to get a more realistic number, there are a few more factors to consider.
First up, the tax man. Let's say that Marge's tax rate is 28%. This means that she forks over 28% to Uncle Sam, keeping 72%. Take her 16% return and multiply it by 0.72 and you get 11.5%. That's Marge's after-tax return. For investors in higher brackets, the effects can be even more profound.
(Next time a friend who invests money short-term tells you her returns, ask her what her tax bracket is. It might look like she's 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 are lower than short-term rates.)
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 makes it take a step back. Let's say inflation was 2.5% during the year Marge held her investment. Taking her 11.5% after-tax return and subtracting 2.5 yields an after-tax, inflation-adjusted return of 9%. (This effect can wipe out much of a money market fund's return.)
For returns covering multiple years, 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, too!
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