The REAL Rate of Return

A few days ago, I came across an article about "The Law of Zero Return", which is a concept that was partly attributed to me. (See http://members.cox.net/mathmistakes/zeroreturn.htm)

The concept is that the combined impact of inflation and income taxes consumes all of the return from an investment.

But that's not exactly what I said or intended to say.

For any kind of investment there is a rate of return, which can be positive, negative or even zero. For example, a bond issuer may offer to pay interest at the rate of 5% on the face value of the bond. This is sometimes referred to as the investment rate or gross rate of return.

Most investors are also well aware of the concept of the "real rate of return", which is defined by investment professionals as the investment rate of return minus the inflation rate. Generally, the inflation rate is assumed to be the same as the rate of change in the Consumer Price Index. If the investment rate of return is 6% and the inflation rate is 2%, the real rate of return in 4%.

Most investors are also aware of the after tax rate of return. This is defined as the investment rate of return minus the rate of tax as a percentage of the investment. And it varies from one investor to another depending on their own marginal tax bracket. For a taxpayer who is paying the maximum 35% federal income tax plus a 5% state income tax on his/her investment income, the combined income tax is equal to 40% of the investment rate of return. So if the investment rate of return is 6%, the income tax rate on the investment income is 40% times 6%, or 2.4%. Thus, the after tax rate of return is 3.6%.

But few investment advisers like to talk about the after tax real rate of return. Perhaps that's because it is a very depressing concept for any fixed income investor.

If the rate of inflation is 2%, and the after tax rate of return is 3.6%, then the real rate of return after taxes is 1.6% on an investment that is paying a gross return of 6%.

Now here's the "fun" part.

If the rate of inflation increases, what usually happens to the gross rate of return?

It goes up, because the people who have money to lend don't want to get repaid in cheaper dollars.

So, let's assume that the expected rate of inflation increases from 2% to 4% and the gross rate of return increases from 6% to 8%. How will that affect the after tax real rate of return?

The taxpayer is still in the 40% federal and state marginal tax bracket, so his 8% is cut down to 4.8% after taxes. But now the rate of inflation is 4%, so the after tax real rate of return is 0.8% instead of 1.6%.

And if the rate of inflation rises to 8%, the investment rate of return would increase to about 12%. The tax rate would be 4.8%, leaving an after tax rate of return of 7.2%. But now the inflation rate is 8%, so the after tax real rate of return is - 0.8%.

The result is that as the rate of inflation increases, the investment rate of return generally increases by an equal percentage and the after tax real real rate of return will decrease.

Like many other elements in investments and economics, there isn't a perfect correlation between inflation rates and rates of return on fixed income investments. However, I did a study in 1986 of various fixed income rates and the CPI inflation rate from 1940 to 1986 and the correlation was very high. The difference is due to the fact that investment rates are set by investors who add the expected rate of inflation to the interest rate that they require. Thus, the inflation adjustment is based on projections of the rate of inflation by investors. The actual rate of inflation will turn out to be more or less, depending on how the Federal Reserve attempts to deal with the problem.

But whatever the Fed might choose to do, it's not a good idea to wish for higher interest rates because higher rates are usually an indication of increasing rates of inflation in the economy. During periods of low inflation rates, investment rates of return are generally very low. And when investment rates of return are very high (as in the late seventies), the rate of inflation is also high.

Vern

www.offshorepress.com