How can you account for inflation in evaluating your portfolio's returns? 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 taxman. Let's say that Marge's tax bracket is 28%. This means that she forks over 28% to Uncle Sam and keeps 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 his or her returns, ask that friend what his or her tax bracket is. It might look as though your friend is earning a higher return than you are -- until you figure in taxes. And commissions. To reduce the tax bite, consider holding stocks for longer than one year to qualify for long-term capital gains tax rates, which currently top out at 20%.
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 one step back. Let's say inflation was 2.5% during the year of Marge's investment. Taking her 11.5% after-tax return and subtracting 2.5 percentage points 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, 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 the nifty inflation calculator, too!
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