Investing Basics: What Is Real Return?

Posted on September 10, 2015 at 6:30 AM PDT by

Retirement investors are hit with a barrage of arcane terms, and among the most arcane is “real return.”

What do we mean by “real” when it comes to money? Not counterfeit?

No, real return is what you actually have after subtracting the costs of investing and the effect of inflation. It’s the spending power your end up with at the end of the process, minus all the drag.

real return

Real return is a big deal, and you should understand all of the sources of spending-power drag on your ultimate return. The reason why is compounding: Every penny you keep is reinvested in your name.

Conversely, every penny you lose to costs and inflation is a real loss, now and well into the future. Lowering your cost of investing matters — a lot.

Let’s start with inflation. You cannot avoid or erase it. Your money will lose value over time no matter what. But you can overcome it with growth.

Inflation is fairly constant. You can expect inflation of roughly 3% per year. It might be more in some years than others, but over the long run it’s predictable.

That’s why you own stocks in a portfolio. Over the long, long run, research has shown, stocks return about 6.6%. How? By reinvesting dividends.

When you own a stock, you get to experience appreciation as the price of the stock rises over time. That’s a reflection, in part, of growth of the economy itself. But companies don’t just get by, they make money.

If you take that money out as dividend income, you can bet your stock investments will perform at about the level of inflation over time. Reinvest the dividends and you get that internally compounding power that drives a portfolio higher.

What else drags your balance down? Fees. When financial advisors charge you for their management and advice, they take money from your account like clockwork.

Problem is, the fees are not based on their performance at all. If your portfolio is flat for the year, a zero percent return, they still take their portion of it as payment.

In many cases, that’s 1% for the advisor and another 1% for the mutual funds they buy in your name. What’s 2% of your portfolio? A lot of money!

Keeping real return

If you have a $100,000 balance in an individual retirement account (IRA), that fee will be $2,000. If your investments end the year up 2%, the fee wipes out the gain completely. Your actual cost of management is not 2%, it’s 100% of your gains.

Finally, consider taxes. If you invest in a taxable account, that’s great. But don’t ignore your workplace 401(k) or personal IRAs in favor of taxable investments.

Investment taxes are hefty indeed, and they are levied on both capital gains and on dividend income. If you can, max out your tax-deferred accounts, such as traditional IRAs, and tax-free accounts, such as Roth IRAs, first.

The end result of cutting financial drag on your retirement accounts it more money. If you have years to go before retirement, a lot more money, thanks to compounding. The key is to make decisions early and stick to your plan.