When you’re hungry, the only thing you really care about is what you can eat. Investing is like eating in that there is only one thing to care about – “returns you can eat.” Let me explain. You may have heard of this quote from Robert Kiyosaki, “it is not what you make, it is what you keep.” The purpose behind this analogy is simple – understanding what you earn, after you pay investment fees, income taxes, capital gains taxes and considering inflation is what matters most. Before an investor or their advisor touts a rate of return, it is vital to understand the other costs associated with those portfolio returns in the aggregate.
Now we can unpack the concept of “returns you can eat.”
Stock market index returns – the illusion
The media reports daily on stock market index returns. But you can’t get the exact return as the stock market index. You can get most of it, but not all. You can buy a fund that mirrors that index, but you will have to pay:
- A commission to buy it,
- The fund management company a fee for creating and managing that fund, and
- Uncle Sam his take if the fund is not in a qualified account
So, after expenses and taxes, you have far less return than the reporter on the radio told you the index did for the day. (Why don’t they mention that?) Your “real” return is what’s left after fees and after taxes.
Inflation – the forgotten money eater
But wait, there is one more “fee” lurking behind the scenes. Inflation. Let’s say that your real return after fees and taxes is 15% for the year. And let’s say that the prices of goods and services that you buy went up by 5% that year. Your real, real return is only 10%, right? So, the returns you can eat, then, are your “real, real” returns – left after you account for expenses, taxes and inflation. This is the only thing that matters in investing.
Choosing investments – going against conventional wisdom
You have the choice between two investments. Is it always better to choose the one with the best historical performance? No, because one may be more tax-efficient than another. Is it always better to choose the one with the lowest fee? No, because the higher-fee fund may have better management and future performance. Bonds are always safer than stocks, right? Not always. When you adjust for inflation, bonds have experienced periods of massive losses in purchasing power for their owners.
What is the only thing that matters?
Investing is very complicated. Writers and commentators often over-simplify to appeal to the widest possible audience. One fund company says, “The only thing that matters are fees and expenses!” Another firm says, “The only thing that matters is performance”. Some firms argue, “The only thing that matters is after-tax performance.” A finance professor says, “The only thing that matters is inflation-adjusted performance.” They are all correct in that those things matter. They are all also wrong to say that their preferred measure is the “only thing” that matters.
When you are hungry for more purchasing power, the only thing that matters are the returns you can eat. Stay focused on the after-fee, after-tax, after-inflation return.
Take some time to let that digest and email me at MichaelC@hh-wm.com if you agree or disagree. If you like this post, send it to a friend; if you hate it, send it to an enemy!
Henry+Horne Wealth Management