Real Rate of Return

By Jason Fittler

To grow wealth you need to take risks.

Wealth is created when your personal wealth increases faster than inflation after tax is accounted for.

Lets break down this statement:

  1. Inflation – this is the rate, which the cost of an item increases over time. The Reserve Bank measures inflation and generally looks to maintain inflation at 3%. This is the level that economists have decided is a reasonable rate of growth. However inflation will be higher and lower at any given point than 3%. We will however work our calculations for this example at 3%.  So if you were to purchase a widget today for $10,000, in a year’s time it would cost $10,300. To keep pace with inflation you need to ensure that your investments have also increased by 3%.
  2. Tax - we all pay tax on any income we earn so to ensure that you are increasing your wealth you need to measure your wealth in after tax terms. For example, if you hold a term deposit of $10,000 currently invested at 3.9% for 12 months, a year later you have $10,390 before tax. But to see if you have increased your wealth you need to know the after tax value of the investment. If your average tax rate were 25% then tax would be $97.50 ($390x 25%) as such your investment is now worth $10,292.50.

When you combine these two factors you have a real return for the past 12-months of negative $7.50 or negative 0.075%. In other words, you are going backwards.

The real rate of return is a true guide as to whether you are getting richer or poorer in relative terms compared to your peers. Historically the real rate of return was 0% or less if you held cash earning no interest at all. However since the GFC your real rate of return will be negative if you are invested in any of the following:

  1. Cash
  2. Term Deposits
  3. Short Term Treasuries
  4. Government bonds
  5. Investment Grade Bonds

This is a very unusual situation to find the financial world in; investors are now required to look for more risk just to break even. Cash and term deposits are no longer a long-term viable option, how long this will last will be determined by how long the world’s largest economies continue to keep interest rates at all time lows.

If you are an older investor who is happy for your wealth to run itself down then you should not worry too much about this situation. However if you are younger or you do not hold enough money to see you through your retirement then now is the time to be speaking to a financial advisor.

Investors look to invest in cash for safety. However, holding cash (as seen by the above example) carries a long-term risk. By playing safe and trying to protect your saving (by investing in cash) you could be losing it.