“The habit of saving is itself an education; it fosters every virtue, teaches self-denial, cultivates the sense of order, trains to forethought, and so broadens the mind.”
— T.T. Munger
Definitions and Example
Rate of Return is the ratio of the annual income from an investment to the original investment, often expressed as a percentage.
Real Rate of Return, also known as the “net” rate of return, is the gross annual income from your savings and investments (S&I) less taxes and inflation. The equation looks like this:
Income from S&I – Taxes – Inflation = Real (Net) Income and expressed as a percentage.
S&I Beginning Year Balance: $100,000
S&I Ending Year Balance: $107,500
Gross Income Earned : $7,500
Gross Rate of Return on S&I: 7.5%
Taxes of 20% on income earned: $1,500
Inflation of 2% applied to year-end balance: $2,150
Real (Net) Income for the year: $3,850
Real (Net) Rate of Return on S&I: 3.85%
The above example clearly shows why you need to use Real (Net) Rates of Return when making long-term S&I plans and commitments. You also need to set a “target” for your real rate of return in your funding and planning strategies.
Your target Real (Net) Rate of Return will help you determine what types of savings and investment products to utilize. In general, the higher your target, the more risk you must be willing to take.
Risk, Reward and Balance
Types of Savings and Investment products
High risk: Below investment grade bonds or bond mutual funds. Stocks or stock mutual funds of start-up businesses. These offer the potential of high rates of return. You also stand the risk losing some or all of your money.
Average risk: Stocks, stock mutual fund, S&P 500 indexed funds, investment grade bonds and bond mutual funds. Returns are not guaranteed. However, over periods of 15 years or more, stocks and stock mutual funds have performed quite well against all other types of investments. S&P 500 indexed funds offer some stability over individually owned stocks because of the number and diversity of the companies included in the S&P 500.
Real estate also has the potential to provide good returns.
Low risk: Includes bank or credit union savings accounts and certificates of deposit. Accounts (up to a certain amount) are insured. Interest rates on certificates of deposit are guaranteed. Unfortunately, the current interest rates for these accounts are typically less than the inflation rate. This means you are guaranteed a loss of the purchasing power of your money.
Balanced S&I Portfolio
The surest way to get caught with your financial pants down is to:
- Seek the highest interest rate
- Seek the highest rate of return
- Putting all of your money in one basket
This doesn’t mean you shouldn’t compare products and services. Just remember that if it looks too good to be true … it probably is. Do your due diligence research.
Your savings and investment portfolio needs to be balanced between high-risk and low-risk products. Your S&I portfolio should contain guaranteed and non guaranteed products.
Don’t be greedy. Don’t get starry-eyed. Rather, have a balanced, well-funded and planned S&I portfolio. Review it annually and make any needed adjustments.
I am not a financial planner or investment advisor. Please seek professional counsel for personal advice and recommendations based on your specific, personal objectives.