Inflation and the real rate of return

By Kevin Theissen

The real rate of return is an important personal finance concept to understand.

It’s the rate of return on your investments after inflation. The real rate of return indicates whether you are gaining or losing purchasing power with your money.

So, if inflation checks in at a rate of 3%, does that mean cash or any investment with less than a 3% rate of return is losing purchasing power?

That’s where it gets a little complicated.

In theory, any investment with less than a 3% rate of return may lose purchasing power. But there are other factors you want to consider as well. For example, are inflation rates likely to continue their current trend, or are they transitory effects of broader market changes?

Interest rates in the U.S. averaged 5.48% from 1971 until 2021, reaching an all-time high of 20% in March of 1980 and a record low of 0.25% in December of 2008.

The annual inflation rate in the U.S. surged to 6.2% in October of 2021, the highest since November of 1990 and above forecasts of 5.8%. Upward pressure was broad-based, with energy costs recording the biggest gain (30% vs 24.8% in September), namely gasoline (49.6%). Inflation also increased for shelter (3.5% vs 3.2%); food (5.3% vs 4.6%, the highest since January of 2009), namely food at home (5.4% vs 4.5%); new vehicles (9.8% vs 8.7%); used cars and trucks (26.4% percent vs 24.4%); transportation services (4.5% vs 4.4%); apparel (4.3% vs 3.4%); and medical care services (1.7% vs 0.9%). The monthly rate increased to 0.9% from 0.4% in September, also higher than forecasts of 0.6%, boosted by higher cost of energy, shelter, food, used cars and trucks, and new vehicles.

In the end, the real rate of return is only one factor to consider when building a portfolio. Taxes are another variable. Your time horizon, risk tolerance, and goals are the primary drivers.

Kevin Theissen is the owner of HWC Financial in Ludlow.