The return on your investment portfolio helps
you evaluate the progress you're making toward your financial
goals. For example, if your long-term projections require that
you achieve an 8% annual return, you may have to
reallocate
your assets if your return falls below that mark over a period
of time.
What
complicates the picture is that
inflation
reduces the buying power of your investment return, as well as
your investment income. If the inflation rate is 3% in a year
that your investment provides an 8% return, your
real return, or return after correcting for inflation, is 5%.
The greater your real return, the larger your account value grows.
Real return is the primary reason that emphasizing
capital preservation
to the exclusion of growth can leave you
short financially over the long term. That's because your
return on the most conservative investments rarely exceeds the
rate of inflation by a full percentage point — and is frequently
less. If you're earning 1.75% on an insured money market
account when inflation is 2%, you have a negative real return
of 0.25%.
Subtracting taxes Computing real return isn't
the end of the line. You also have to correct for
income taxes on realized gains and investment income.
That's the reason that tax-deferred and tax-free
accounts are such attractive ways to invest. You postpone
having to subtract the tax that's due — or avoid it altogether.
What
complicates the picture is that
