The reasons to consider a real return
Inflation can’t be dismissed, even if monetary policymakers do all they can to keep it under control
Do you know the numerous means by which institutions and you might choose to measure your investment returns? Risk-adjusted, real, net of taxes and absolute are just a few of the measures we apply to discern whether or not what clients need and what they want are in sync. Too many retail investors focus on absolute returns while ignoring the reason they invest in the first place – to maintain their purchasing power in the future or to fund a future dream or obligation.
What is a real return? Imagine it like a stalk of corn shorn of its green husks. It is the core investment return we receive when we adjust for the insidious loss of purchasing power due to inflation.
For example, if you invest in a security that has had a return, that return is the actual or absolute rate of return. The real rate of return, one which is our benchmark, focuses on the actual future purchasing power of the invested assets when inflation is taken into account. It is a real rate of return that matters when the time comes to make the transition from creating a nest egg to distributing our hard-earned savings to replace previous wages.
Wages sometimes grow alongside inflation, but when we stop working, we need and want our nest egg to provide the same level of security in the future. Absolute returns are nice measurements to think about, but their actual value is more metaphysical than not. Real returns matter if you are genuine about truly funding a secure retirement, that future dream home, or a world cruise with your best friends.
Too often ignored
Real returns are also material because sooner or later we can hit an inflationary speed bump.
Amazingly, many savers hardly pay any attention to inflation beyond an occasional quarterly glance to make sure the beast remains tamed. Such complacency is understandable because inflation has not been a serious economic issue for more than two decades in the developed world.
But inflation can’t be dismissed, even if monetary policymakers do all they can to keep it under control. As former Federal Reserve Chairman Alan Greenspan said, “In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value.”
I have been a strong advocate for teaching financial literacy ever since our now 27-year-old was in 8th grade. Many lessons are equally applicable to adults who have taken far too much for granted in recent years.
We have all heard stories of folks who purportedly survived the Great Depression by trusting neither banks nor investment advisors and put cash under their mattresses or buried tobacco tins filled with the same in their backyards. Even with the minor inflation we have experienced recently, playing it too cautious with cash alternatives currently can generate negative real returns. Those dollar bills buried during the Depression have far less purchasing power today – except perhaps as collectables.
Inflation is one aspect that is too often ignored when it comes to risk assessment, but it’s critical to factor in especially as more baby boomers retire and the composition of the labor force changes. That is why we focus on our historical real returns over time and largely ignore the media buzz surrounding the current boom in the stock market.
It’s easy to forget about inflation and easy to bury the memory of the devastating effect inflation had in the 1970s. It is periods like those – along with the dot.com bubble of 1999-2000 or the housing market bubble of 2006-2007 — when investors forget the historical gravity of markets and begin to buy at the top with hope that there is another level to sell above it.
There may or may not be higher levels ahead in this current bull market, but if inflation starts to emerge for any number of reasons – particularly if a currency war erupts – then ignoring the power of a real return measurement can lead to a real devaluation of one’s assets. That would be the unkindest cut of all.
Tom Sedoric, managing director-investments of the Sedoric Group of Wells Fargo Advisors in Portsmouth, can be reached at 603-430-8000.