Real, Real Returns Are All That Matter

WHEN we consider fees it’s important to remember that investment managers aren’t the only ones charging fees on our investments. The government also charges fees in the form of taxes and they can add up to sums that are even more impactful than investment management fees.

Further, there is another fee that you might not see, but is always lurking – inflation. Simply put, inflation is when the price of a broad basket of goods and services increases and as a result $1 of nominal income buys less with time. Your portfolio of assets might rise or fall, but if you earn a return that is equivalent to the rate of inflation, you are not actually better or worse off. You are merely running in place. That’s why you should always consider the impact of inflation on your portfolio.

When we consider the risks to our portfolio, we need to balance the risk of principal losses with the risk of purchasing power loss. After all, we all want stability of our portfolio with maximum growth. Unfortunately, these two things don’t always go hand in hand and, in fact, you usually need to sacrifice short-term stability in exchange for long-term growth. The stock market, for example, can be extremely volatile in the short run, but will generate high real returns in the long run. Something like cash, on the other hand, will be very stable in the short run and provide significant principal stability but will also expose you to higher risk of purchasing power loss in the long run.

To build a portfolio that protects you from principal instability and purchasing power loss you need to balance these risks while always optimizing your returns to account for the dilution that can come from taxes, fees, and inflation.

Most investment data is quoted in nominal terms. In this book I quote the investment returns in real terms to account for the most damaging fee of all – inflation. More importantly, when I analyzed these portfolios, I tried to focus on portfolios that would be good inflation hedges in the long term.