Source: WSJ



I wanted to take a moment out this morning to briefly discuss the differences between real, nominal, after tax, and total returns:

Why is it that nearly any chart that gets posted — be it index, stock, bond or commodity — invariably results in a knee jerk demand for an inflation adjusted version? I half expect to see those comments on even intra-day stock charts.*

Different return measures (and the corresponding charts that go with them) provide information about different things. It is not, as some suggest, that one is inherently superior to another. Rather, they measure different things, provide a different context, and are appropriate in different circumstances.

Perhaps a few definitions are in order:

Nominal Returns: Are what an investment generates before taxes, fees and inflation. It is simply the net change in price over time.

Real Returns: Are the actual value of your returns, typically after adjusting for inflation and fees. During a period of high inflation (i.e., 2001-07), Real Returns inform the gains minus inflation by keeping purchasing power of capital constant over time.

Net Returns: Usually referenced in the context of high fee investment vehicles like VCs or Hedge Funds. Net returns informs the investor exactly what they have left after managers take their pound of flesh. Can reference net of fees and/or taxes and other expenses. (Related definition: Net Return Shock!)

Total Returns: Is the combination of both capital appreciation (change in market price) plus all interest, income, dividends and distributions.

After-Tax Returns: Usually used in reference to tax-advantaged securities (i.e., municipal bonds, TIPS), it is the actual financial benefit which accrues to an investor on an after tax basis. The after-tax return often differs significantly from the nominal rate of return. It is dependent upon the investor’s city and state of resident, Federal tax bracket.

All of these return measures are valid ways of depicting slightly different measures of investing results. They seek to gauge returns in slightly different forms relative to each other. They actually measure different things, and each are more (and often less) appropriate in specific settings.

While the numbers used to depict these varied forms of returns are neutral and objective measures, how they are employed often is not. I see an awful lot of biases revealed in some quarters always selecting one type of return or another. Always showing inflation adjusted returns is an attempt to reduce the returns of a rally, typically one missed by the speaker. Never showing inflation adjusted or Total returns reveals a similar if opposite bias.

Which brings us to the chart shown up top. If you want to get a true picture of returns, inflation adjusting alone is misleading. Consider the typical investor saving for retirement in an IRA or 401k. For these investors, the real inflation adjusted return is important, but so is their total return. Their real total return informs them both of the dollar amount of their investments’ worth plus any change in its purchasing power.

This leads investors to the most important questions about their long-term investing in the first place. It is a fair question to ask: How much money will you have when you retire, and what will that sum of money be worth?






* Yet another reason to look askance at comments.

Category: Inflation, Markets, Really, really bad calls

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

12 Responses to “Which Type of Returns Are You Referring To ?”

  1. rd says:

    Total Net Return (after expenses) and Inflation-Adjusted Total Return are the two I focus on. As
    I get closer to retirement, I am focusing more on inflation-adjusted returns since much of my earnings potential is already past me and the past savings are going to be a major driver in my financial success during retirement where inflation has the potential to be a primary eroder of wealth. it is also very easy to get caught up in the price of something (e.g. S&P 500 index value) without accounting for the income and reinvestment stream that the asset can provide to your portfolio. However, retirees are starting to become educated that high asset prices arent helping them realize adequate income streams at this time.

    Earlier in my careerr, I focused more on nominal returns because I anticipated that my pay would rise at or above the rate of inflation over the years (which it has), so that future savings would be increasing at or above the rate of inflation which would provide for much of the increase in the portfolio.

    I find the calculators that postulate your future wealth with a constant stream of uniform savings over your career while then calculating your total wealth at the end using nominal returns to be very annoying as this is not how actual savings streams and spending power generally work in practice. Some of these calcualtors are used to demonstrate that you can get enough savings in your 20s to generate a million dollars at retirement using nominal returns. Those calculators usually don’t mention that the million dollars will only be worth a couple of hundred thousand in actual spending power and you need to continue savings after your 20s.

  2. Casual_Observer says:

    The chart would really be much more helpful, and objective, if it were denominated in Klingon Darsek.

  3. [...] What kind of returns are we talking about?  (Big Picture) [...]

  4. wally says:

    Since a dollar in 1990 is not the same thing as a dollar in 2000 or in 2010, any calculation which does not account for that is adding apples to oranges to grapes. I would never lay out a spreadsheet or a chart or do calculations without correcting for that.
    Others may do as they please, of course.. even get snarky if they’d like. However, they’d still be doing incorrect arithmetic.

  5. RandyS. says:

    Certainly both measures are important. However, a typical investor need only look at their statement for total return figures. It’s the inflation-adjusted return that may be missing. My broker statement’s don’t provide it. I have to calculate it myself — which of course allows me to see the true earning potential of the investment.

    Clearly, some quarters engage in selective presentation of data, but might the request often occur because it’s a missing measure for many passive investors? Does Fusion provide an inflation-adjusted return calculation on it’s client’s statements? That’s an honest question by the way, not a ploy in the “gotcha game.” I hate that I need to qualify the question, but Internet comments being what they are…

  6. RW says:

    As others have mentioned or intimated, monitoring investment performance is not as simple as averaging returns reported investment firms (even if you use the same firm for all investments) because these period-to-period returns do not take into account your investment timing decisions, reinvestment, commissions, fees and taxes, etc so getting to the net return on investment, appropriately adjusted for inflation and/or risk, is not trivial.

    That is, if you really want to get to the true return on investment, you rather minimally need to compute using the internal rate of return (IRR) method so that the timing and amount of all cash flows into and out of an investment is taken into account (this is also a total return because it includes both income and capital appreciation).

    It’s remarkable how few retail software packages do this …in fact, at the moment, I can’t think of a single one but I’ve use an older version of a professional program for the past couple decades and haven’t looked. Anyone else out there aware of the current state of affairs in DIY investing software?

    NB: No snark from here Wally; real, risk-adjusted total return is probably the sine qua non of any savings plan (which should logically include an investing component if one expects to maintain purchasing power).

  7. realist50 says:

    I agree with Barry’s point. In fairness to the WSJ, though, the following paragraph was in the article today with the graph that Barry pulled:

    “Some economists and analysts said it is important to add dividends and subtract taxes when measuring the Dow’s gains. Counting dividends would increase the Dow’s gains, while removing taxes would reduce them. Counting dividends and taxes requires assumptions about reinvesting dividends and about whether the account is taxable. Even with most measures of dividends and taxes, however, the inflation-adjusted Dow still isn’t back to its 2000 record.”

  8. I personally prefer to work in terms of total returns including dividends and interest etc and net of all fees, commissions and other hidden costs.

    There are two reasons for not worrying about inflation most of the time. The first one is that while I can easily control my investment choices, I cannot control inflation. From an time-investment perspective it’s a net loss to worry about stuff outside my control. The second reason is that the consumer price index is not especially well measured, the process by which it is poorly measured has been repeatedly changed over time, and the inflation that any one person faces is idiosyncratic anyway – it depends on where you live and how you live. I’d prefer to live with less certainty (and thus be more careful) and to use my own inflation metrics, than to suffer from a false sense that I understand inflation based on a flawed nationally-averaged CPI statistic.

    Working with total returns is usually fine. One almost always prefers a higher return over a lower one! But one has to be careful, doing comparisons, to be sure that equal time periods are used. A 5% return in the 1970s was much easier to achieve than a 3% return today.

    One other comment I wanted to make is that going for a higher near-term return (of any sort) is not always right either. Sometimes you have to forego the high-yield bonds and/or the hot momentum stocks in order to avoid being bit by the crash just ahead.

    What I really look for are sustainable gains. (Hence the name.)

    P.S. First comment here, but been an avid reader since 2006.

  9. flakester says:

    “Always showing inflation adjusted returns is an attempt to reduce the returns of a rally, typically one missed by the speaker. Never showing inflation adjusted or Total returns reveals a similar if opposite bias.”

    Then always show them both when the time period of the chart is long enough, as you did.

  10. PK says:

    As an overly pedantic lurker, I’ll note that taking S&P 500 Total Return and CPI-U (Seasonally Adjusted – and interpolated daily values a la TreasuryDirect) leaves March 24, 2000 as the ‘actual’ peak. Using the data we have now, I estimate a ~ -3.9% return from the peak (my work: – feel free to delete if this link is too self serving).

    One reason I think it’s important to note? The government may change income tax brackets for inflation, but it certainly doesn’t factor them into investment returns. If you bought at the peak and sold today you’re paying tax on a ‘real’ loss, IRA/529/401k/etc aside. I like Total Returns as well – most financial/mainstream press ignores the effects of any dividends (an error that grows with time). Even if you spend 100% of your dividends, that’s still a significant return to ignore.

    Even in my pedantism, though, I note there are some shortfalls to my method. Namely… where does an investor go if he wants to buy a reinvested S&P 500 fund with 0 management fees that never owes taxes? And thus, the argument continues.

  11. PK says:

    RW, I use XIRR with Excel/OpenOffice – take your pick. On the ‘last day’, pretend you ‘sell’ everything in your portfolio. Back out transaction fees if you’re incredibly detail oriented. I update my spreadsheet once a year and compare to the S&P 500, to make sure I’m not wasting time on individual stocks. During the year I let Google Finance give me a rough idea (it’s not incredible when you add to your portfolio, but it gives you a decent idea). You know – at one point Quicken did it. Not sure if it still does, or even if it tracks everything correctly.

    On the topic of inflation, you can get just as far into the weeds. CPI-U? Sure, that’s accepted. But if you’re older and have more medical expenses versus if you’re younger and have kids in college your personal inflation rate diverges wildly. We’ve also got all sorts of fun, exotic indices now – PCE deflating, chained CPI, even the Billion Prices Project (from MIT – don’t show any gold bugs it’ll get them going about understated inflation).

    I think it’s best to point to a benchmark accepted in advance. Say, the S&P 500. Or, 60/40 S&P 500 and 10 Year Treasuries. Personally, if I beat the S&P I’m happy.

  12. [...] bottom line: Returns can be calculated and illustrated in many different ways, and whoever is doing so may well have an agenda. Meanwhile your first emotional reaction may well [...]