DISQUS

J at Home Finance Freedom · 2 years ago

Hello. I have not checked the math here but I agree with your broad point and recently made a similar point using the Vanguard 500 fund as an example (click name link).

bripblap · 2 years ago

J, you make an excellent point on your blog. There's a lot of salesmanship going on around these funds, even the "nice" ones like the Vanguard index funds. There's no advantage for these funds to mention that after inflation they have practically no returns, which leads to a lot of false choices being thrown out in the personal finance blogs.

J at Home Finance Freedom · 2 years ago

Yes, a true 5% is not bad and might be better than alternatives but we need to be realistic to avoid unpleasant surprises.

Thank you for the visit and feedback.

SavingDiva · 2 years ago

I agree that we need to plan for the worst. I think a lot of people don't include inflation in their retirement calculations. I'm at a stage in my life where I'm just trying to get used to putting away a percentage of my income...I haven't really started any long term planning...

Pinyo · 2 years ago

Many people do use the 10-11% (I do myself) for investment discussion. You are right that these discussions typically do not include tax and inflation. And the post did a good job of raising the issue. However, I think the statement "after inflation they have practically no returns" is also an overstatement. Based on the inflation calculator: http://inflationdata.com/inflation/Inflation_Ra...

The inflation rate between 1926 and 1999 is about 818% (i.e., a $1 in 1926 worth $9.18 in 1999). On the other hand, a 10% annualized return $1 invested in 1926 would be worth $1,150 in 1999. They are hardly comparable.

Also, many people now invest in Roth IRA and 401k, essentially allow them to avoid tax on gain which helps even further.

bripblap · 2 years ago

Pinyo, you are right that "no returns" is definitely an overstatement. I guess my only counterargument to that would be that 10-11% is an overstatement as well, so the truth is somewhere in between. Investing in retirement accounts is a good way to avoid the taxes on gains but at least in my case some of the returns are being eaten up by the fees on my very limited selection of funds. Plus, I'm not 100% convinced that the IRA/Roth taxation policies are set in stone. With the looming Social Security/etc. crisis, changes in tax policy are always possible...

Pinyo · 2 years ago

Agreed, fees are very evil and can really rob you of 50% or more of you potential investment. I wrote about this not long ago.

Yes, you bring up a valid point about taxation policies. It is as imaginary as our currency -- i.e., our money is only as good as the stability of this government since it is no longer backed by gold.

bubelah · 2 years ago

BTW, my foreign investments are doing much, much better than my US ones.
Check out CHU stock (Chinese). I bought 1000 shares about 2 years ago for $7.00, at some point (recently) it went up to $17.00.
Also, check out MTL (Russian).

bripblap · 2 years ago

@Lora: The biggest question about foreign investments is the stability or lack thereof of their markets. The US can at least claim fairly good stockholder protection laws. I'm sure most people feel fairly confident buying Chinese stock, but as you go more and more remote the risk you'll have your investment disappear is higher. Russia has some great investment possibilities - but then again Yukos looked good before Khodorkovsky was thrown in jail and the company was broken up.

Hunter Nuttall · 1 year ago

I think this is a great illustration of how much better stocks are than bonds. Although the growth rate is roughly only double, the real return is roughly ten times as much. This is because bonds first get hammered by taxes, and then inflation subtracts a flat 3.1% regardless of what the earnings are.

However, the chart is just plain wrong in assuming that all of a stock fund's returns are subject to federal income tax. Capital gains rates are more favorable, and unrealized gains aren't taxed at all (until they are realized).

I just pulled some performance data on Vanguard's S&P 500 Index Fund. The 5 year annualized return is 12.69% before taxes, 12.39% after taxes on distributions, and 11.08% after taxes on distributions and sale of fund shares.

In my post "How To Create A Seven Figure Residual Income" (see my link), I assumed a 10% rate of return, which was meant to reflect a mix of large caps and small caps after taxes were paid on distributions. I think this is a fair assumption if you can ignore inflation, which you may or may not be able to do depending on the purpose of your calculations.

Steve (Brip Blap) · 1 year ago

Hunter, the chart doesn't assume that stocks are subject to the full income tax. It's looking at the overall trend in capital gains taxation rates - 31% is the historical norm. Recently, of course, the rates are very low, but in the past capital gains were taxed at a higher rate. In 2010 the current rates revert to the pre-Bush-tax-cut rates unless the rate cuts are extended; I do not have that much trouble imagining an increasingly debt-ridden US government increasing taxes on capital gains to make up budget shortfalls - does anyone doubt they will try?

Hunter Nuttall · 1 year ago

Sorry Steve, I missed the part where you said 31% was the historical norm for the capital gains tax. However, I don't think that's what the chart is saying. Page 2 of the chart says "Less Federal Taxes." That must mean federal income taxes, right? Granted, they're talking about a CD on page 2, so federal income taxes would apply, but they seem to be applying 31% federal taxes to the stocks on page 1. I don't see them saying that 31% is the historical norm for capital gains taxes (although it may very well be true). Futhermore, the chart assumes that all of the gains are realized and therefore subject to tax.

There's something that just occurred to me--please double check me on this. Let's say you get a 4% return, and inflation is 3%. What's your real return? 1%, right? No, I don't think so.

Let's say you start with $100 in 1999, gain 4% to have $104 in 2000, and inflation was 3% over that 1-year period. If inflation was 3%, then $100 in 1999 dollars is worth $103 in 2000 dollars. So that means you start in 1999 with $103 in 2000 dollars, and in 2000 you have $104 in 2000 dollars. The gain from $103 to $104 is 0.97%.

I'm not sure if my assumptions about how they measure inflation are correct here. Like I said, please double check me.

Steve (Brip Blap) · 1 year ago

I don't disagree with your inflation statement. They made a simplifying assumption, and inflation is an arbitrary number in the first place (home prices and oil, for example, are not included in the government's calculation). Over a 20-30 year period the difference in a straight x - y calculation versus the correct way you mention might start to have some effect, but as I said I think it's just a simplification for example.

The 31 % tax is still correct, I think - saying "federal tax" is misleading, but they mean capital gains taxes (which, by the way, were the same rate as "earned income taxes" until the supply-siders came along in the 1980s and decided to tax wage income at a higher rate than "unearned" income).

If you look at the footnote, they are using 1990 capital gains rates, adjusted forward and back in the chart for inflation. As of 1990, the top tax bracket in the US was still paying 31% in capital gains. The lower rates we enjoy now are not typical. So no, I think they mean federal taxes on capital gains, not federal taxes on incomes.

Again, it's a gross simplification for the sake of demonstration. There are multiple tax brackets (someone with no earned income living off their investments would pay 0% capital gains now, for example). I wouldn't hold this chart up as a proof, but only as an example of what happens when you factor other variables into the "rate of return" equation - which also, in the case of mutual funds, excludes fees. It's a convenient way to confuse an unsophisticated investor into thinking they are doing better than they really are.

Dividend Growth Investor · 1 year ago

Well, I think that most bloggers out there use the 10% stock performance norm for simplicity purposes.
Stocks have returned 10-11% annually before inflation and taxes. But the link from 'J at Home Finance Freedom' is an overstatement as well, because he mentions that the Vanguard Fund has returned 12% annually from 1976 with inflation being at 12% untill the early 1980's. What he forgets to mention is the fact that inflation has been closer to the long term average of 3% for the majority of the study period from 1976.
As Hunter Nuttall mentioned, the chart that Steve presented is a little misleading on the taxation issue, because they seem to be subtracting the 31% tax at the end of every year from the performance. In fact, it could be argued that only the dividends from the fund would have been taxable.

What could be argued about the long-term future returns ( without accounting for taxes and inflation) is that the dividend component, which historically has accounted for 40% of average annual returns, has decreased significantly over the past 2-3 decades. With current yields around 2% in the S&P 500, the future returns could turn out to be around 5%...