Are Your Investments Really Earning As Much As You Think They Are?
Leisl L. Langevin, CFP®, CDFA®
Senior Vice President & Financial Advisor
When it comes to making investment decisions, many individuals focus on nominal returns – the raw percentage increase or decrease in the value of an investment over time. However, to truly understand the growth potential of your investments, it's crucial to consider the concept of real return. Let’s explore what real return is, how it differs from nominal return, and why it should be a key factor in deciding what types of investments are best for your unique financial situation.
Understanding Real Return
Real return is the actual rate of return on an investment after accounting for inflation. Inflation, which is the general increase in prices and the decrease in the purchasing power of money over time, can significantly impact the true growth of your investments. For example, if your portfolio earns a 6% nominal return, but the inflation rate is 2%, your real return would be approximately 4%. This means that while your investment grew in dollar terms, its purchasing power only increased by 4%.
Real Return vs. Nominal Return
Nominal return, on the other hand, is the rate of return on an investment before factoring in inflation. It's the figure most often quoted in financial news and investment performance reports. However, relying solely on nominal returns can give you a false sense of your investments' actual growth potential, especially when making long-term investment decisions.
Consider two investments: a corporate bond with a 4% yield and a dividend stock with a 2% yield and 3% expected annual growth. With 1.5% inflation, the bond's real return is 2.5% (4% yield - 1.5% inflation). The stock's real return is 3.5% (2% yield + 3% growth - 1.5% inflation). Despite the stock's lower initial yield, it's the better choice after considering inflation and growth, with a higher positive real return.
Applying Real Return to Investment Decisions
Understanding the concept of real return is essential when deciding what types of investments are best suited for your portfolio. Different asset classes – such as stocks, bonds, and real estate – have varying levels of risk and potential for growth. By considering the real return potential of each asset class, you can make more informed decisions about how to allocate your investments.
Historically, stocks have provided higher nominal returns compared to bonds and cash equivalents. However, they also come with greater short-term volatility and risk. When adjusting for inflation, the real return of stocks may be lower than their nominal return, but they still tend to outperform bonds and cash over the long term.
Bonds, on the other hand, generally offer lower nominal returns but provide a steady stream of income and can help to stabilize your portfolio during market downturns. However, when inflation is high, the real return of bonds may be minimal or even negative.
Real estate investments, such as rental properties or REITs (Real Estate Investment Trusts), can offer a balance of income and growth potential. They also have the added benefit of potential appreciation in property values over time. However, like stocks, real estate investments come with their own set of risks and considerations.
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Tailoring Your Investment Strategy
When making investment decisions, it's essential to consider your personal financial goals, risk tolerance, and time horizon. A well-diversified portfolio that includes a mix of asset classes can help to balance risk and return potential while taking into account the impact of inflation on real returns.
For example, if you have a longer time horizon until retirement, you may be able to afford to take on more risk in your portfolio by allocating a larger portion to stocks. As you near retirement, you may want to gradually shift more of your assets into bonds and cash equivalents to prioritize stability and income.
Regularly reviewing your investment strategy and making adjustments based on changes in your personal circumstances, market conditions, and inflation rates can help ensure that your portfolio remains aligned with your goals and optimized for real return potential.
At WHZ, our experienced financial advisors are dedicated to helping clients make informed investment decisions based on their unique needs and goals. We understand the importance of considering real return when building and managing investment portfolios so that with us you can have Absolute Confidence. Unwavering Partnership. For Life. Contact us today for a complimentary consultation and we can help you develop a personalized investment strategy that maximizes your real return potential.
Authored by Senior Vice President, Financial Advisor Leisl L. Langevin, CFP® CDFA®. Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. 697 Pomfret Street, Pomfret Center, CT 06259 and 392-A Merrow Road, Tolland, CT 06084, 860.928.2341. http://www.whzwealth.com These materials are general in nature and do not address your specific situation. For your specific investment needs, please discuss your individual circumstances with your financial advisor. Weiss, Hale & Zahansky Strategic Wealth Advisors does not provide tax or legal advice, and nothing in the accompanying pages should be construed as specific tax or legal advice.
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