Inflation adjusted - real return

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Topic Author
Dsc8
Posts: 29
Joined: Sat Apr 23, 2022 6:09 pm

Inflation adjusted - real return

Post by Dsc8 »

Hi everybody,


I'm a beginner, and there is an aspect of investing and inflation which is not clear to me, and I need some help to understand it better. I have very big confusion, and I know that I don't understand many things, so perhaps some lines are without sense. I apologize.

Let's assume, that I invest $1million in ETF VT. The hypothetical price per share is $50.

In the first year, the return is 10%. Also, the inflation is 3%. Inflation adjusted is more or less 7% return. Let's assume that I spent all 10% of returns and at the end of the year I left with nothing. I did not reinvest anything.
For 10 years, the scenario is the same.
What happens on 11th year?

My concerns are this:
- I didn't reinvest anything, does my purchase power on 11th year is lower that in the first year? (because the inflation now is 30% higher than before, but my initial $1million is still the same together with $50 per share?) Does the price per share grew up meanwhile, and consequently my initial $1m is way bigger, and my 10% return is adjusted base on the higher capital and therefore my purchase power it is still the same?
- I do not understand if with ETF stocks, to maintain at least the same purchase power, I suppose to reinvest part of returns in order to stay even with inflation. But an ETF stocks is not cash, it is supposed to grow up in price per share. But then again, the total return are dividends + share price increase and since I spend all the returns, I'm afraid that my ETF's price per share remain the same as at the beginning, although it doesn't make sense.
- I don't even understand if the returns about which I'm speaking are only dividends or total returns? How can I check to understand? Usually on websites they write returns, are they speaking only about dividends, or also the increased price per share?

Ideally, I would like to spend all the returns, and maintain the same purchase power through the years, just because the price per share of the ETFs stock (VT) will go up together with inflation. I don't want to worry about inflation if I'm investing in stocks. How historically ETF's stock compare to inflation? Also, I don't understand if an ETF stocks, such as VT, grow up in price per share the same way as traditional share of a single stock company does.

There is also the inflation adjusted term, which create confusion in me. So, I receive 10% ($100,000) from ETF VT, and in inflation is 3%. In practice, I'm able to buy 70k of goods by spending 100k?


Again, I apologize for many mistakes and confusion.
Tamalak
Posts: 1989
Joined: Fri May 06, 2016 2:29 pm

Re: Inflation adjusted - real return

Post by Tamalak »

"Returns" means price increase PLUS dividends. So if you bought 20,000 shares of VT for $50 ($1 million worth), and the first year it went up 6% in price (to $53) and then also paid out 4% in dividends ($40,000), then at the end of the year you'd have:

20,000 shares of VT worth $53 each ($1,060,000 worth)
$40,000 cash
$1,100,000 total net worth
10% returns for the year (your net worth started the year at 1,000,000, and went up 10%. If inflation was 3%, then your real returns are 7%)

If you spend all your returns, that means you spend your $40,000 cash, AND sell $60,000 worth of VT (~1132 shares), and end up with:

18,868 shares of VT worth $53 each ($1,000,000 worth)

Since inflation was 3%, your buying power has gone down 3% since your net worth is unchanged for the year.
mega317
Posts: 5705
Joined: Tue Apr 19, 2016 10:55 am

Re: Inflation adjusted - real return

Post by mega317 »

Tamalak wrote: Tue May 24, 2022 3:17 pm If you spend all your returns, that means you spend your $40,000 cash, AND sell $60,000 worth of VT
I think the selling shares part is important to understand and may help you out.

In your scenario, you start every year with $1M, and the investment earns 100k and you spend 100k, every single year. So every year, if there is inflation, the 100k will buy you less and less. But the absolute numbers (1M and 100k) will go forever unchanged. You will have fewer and fewer shares which are more expensive each, but that doesn't matter.
User avatar
FiveK
Posts: 15742
Joined: Sun Mar 16, 2014 2:43 pm

Re: Inflation adjusted - real return

Post by FiveK »

Dsc8 wrote: Tue May 24, 2022 3:08 pm In the first year, the return is 10%.
That return, for a stock fund, will be a combination of dividends, capital gain distributions, and capital gains. Capital gains manifest themselves as share price increases.
- I didn't reinvest anything, does my purchase power on 11th year is lower that in the first year? (because the inflation now is 30% higher than before
Yes.
but my initial $1million is still the same together with $50 per share?)
No (see first reply in this post above).
Does the price per share grew up meanwhile,
Yes, see above
and consequently my initial $1m is way bigger, and my 10% return is adjusted base on the higher capital and therefore my purchase power it is still the same?
No, your $1m is still your $1m because you decided to remove all gains each year.
- I do not understand if with ETF stocks, to maintain at least the same purchase power, I suppose to reinvest part of returns in order to stay even with inflation. But an ETF stocks is not cash, it is supposed to grow up in price per share. But then again, the total return are dividends + share price increase and since I spend all the returns, I'm afraid that my ETF's price per share remain the same as at the beginning, although it doesn't make sense.
To "spend all the returns" you would have to sell some shares at their increased price. You retain $1m by having fewer shares at a higher price.

Together with Tamalak's and mega317's replies, is it clear(er) now?
Topic Author
Dsc8
Posts: 29
Joined: Sat Apr 23, 2022 6:09 pm

Re: Inflation adjusted - real return

Post by Dsc8 »

Thanks everybody, it is way clearer now.

So basically, in order to maintain the same purchase power I can only spend what is left after subtracting the inflation rate, in my example a 7%.

Well, it is very disappointing. I was looking at 30 years historic returns of VT, and inflation adjusted is only 4%. Then you need to calculate the fees etc. That's why I was thinking to invest in SPY or US total market for better returns, but then again, everywhere I looked people suggest going VT for better diversification. The point is, SPY gives you a reasonable return after inflation, a 6%, which is way better than VT and does make a difference.

I suppose it is better to open a new topic and ask there about SPY vs VT
Tamalak
Posts: 1989
Joined: Fri May 06, 2016 2:29 pm

Re: Inflation adjusted - real return

Post by Tamalak »

Dsc8 wrote: Tue May 24, 2022 3:41 pm Well, it is very disappointing. I was looking at 30 years historic returns of VT, and inflation adjusted is only 4%.
How do you get that?

VT hasn't been around for anything close to 30 years. Even when I approximate it using the earliest share classes of VTI+VXUS (50% each), VXUS only lets me start in 1997 on Portfolio Visualizer.

Starting in 1997, you would get 4.5% real annualized. Starting actually 30 years ago (1992), you would get considerably more, since 1992-1997 had great returns.

But you are correct - if returns are 10% nominal but 7% REAL, then in order to preserve buying power you can only spend 7%. Furthermore, since returns are so unpredictable (and sometimes negative!), you need to spend LESS than the expected real returns in case of a bad sequence of returns. This is called a "safe withdrawal rate". The classic safe withdrawal rate is considered to be 4%, even though historical returns are about 6% real - so you first leave in inflation to preserve buying power (6% real becomes 6% nominal), and then leave in another third as a safety margin (6% nominal becomes 4% nominal), and that final 4% you can spend.

People often talk about reaching the magic "25x" - when your portfolio is 25 times larger than your expenses, then you can retire since you have achieved the point where you can pay for your lifestyle with 4%.
User avatar
FiveK
Posts: 15742
Joined: Sun Mar 16, 2014 2:43 pm

Re: Inflation adjusted - real return

Post by FiveK »

Dsc8 wrote: Tue May 24, 2022 3:41 pm The point is, SPY gives you a reasonable return after inflation, a 6%, which is way better than VT and does make a difference.
It may be that SPY has been better than VT, but the real point should be what do you expect will be better? Good arguments can be made either way....

E.g., see Callan periodic table of investment returns - Bogleheads.
Topic Author
Dsc8
Posts: 29
Joined: Sat Apr 23, 2022 6:09 pm

Re: Inflation adjusted - real return

Post by Dsc8 »

Tamalak wrote: Tue May 24, 2022 3:53 pm
Dsc8 wrote: Tue May 24, 2022 3:41 pm Well, it is very disappointing. I was looking at 30 years historic returns of VT, and inflation adjusted is only 4%.
How do you get that?

VT hasn't been around for anything close to 30 years. Even when I approximate it using the earliest share classes of VTI+VXUS (50% each), VXUS only lets me start in 1997 on Portfolio Visualizer.

Starting in 1997, you would get 4.5% real annualized. Starting actually 30 years ago (1992), you would get considerably more, since 1992-1997 had great returns.

But you are correct - if returns are 10% nominal but 7% REAL, then in order to preserve buying power you can only spend 7%. Furthermore, since returns are so unpredictable (and sometimes negative!), you need to spend LESS than the expected real returns in case of a bad sequence of returns. This is called a "safe withdrawal rate". The classic safe withdrawal rate is considered to be 4%, even though historical returns are about 6% real - so you first leave in inflation to preserve buying power (6% real becomes 6% nominal), and then leave in another third as a safety margin (6% nominal becomes 4% nominal), and that final 4% you can spend.

People often talk about reaching the magic "25x" - when your portfolio is 25 times larger than your expenses, then you can retire since you have achieved the point where you can pay for your lifestyle with 4%.
I got data from a website, I'm not sure if I can write the name (forum rules?), anyway it is fake data judging by your post.

About the magic "25x", is it calculated pre taxes? Because in my case I need way more than 25x in order to pay all my expenses and taxes with 4% returns (I also need to pay the wealth tax, since I'm living in Switzerland)
Topic Author
Dsc8
Posts: 29
Joined: Sat Apr 23, 2022 6:09 pm

Re: Inflation adjusted - real return

Post by Dsc8 »

FiveK wrote: Tue May 24, 2022 6:02 pm
Dsc8 wrote: Tue May 24, 2022 3:41 pm The point is, SPY gives you a reasonable return after inflation, a 6%, which is way better than VT and does make a difference.
It may be that SPY has been better than VT, but the real point should be what do you expect will be better? Good arguments can be made either way....

E.g., see Callan periodic table of investment returns - Bogleheads.
Thank you for the link, food for thought.

So yeah, it is safer going global. I just don't understand why such players as Buffett and perhaps even Bogle are against going outside US, or it is not true?
User avatar
FiveK
Posts: 15742
Joined: Sun Mar 16, 2014 2:43 pm

Re: Inflation adjusted - real return

Post by FiveK »

Dsc8 wrote: Wed May 25, 2022 2:51 pm About the magic "25x", is it calculated pre taxes? Because in my case I need way more than 25x in order to pay all my expenses and taxes with 4% returns (I also need to pay the wealth tax, since I'm living in Switzerland)
Yes, the 4% "rule" (and the equivalent inverse, 25X) includes all expenses, including taxes and investment fees. Also, much of the Safe withdrawal rate studies have used US historical data. Don't know if similar work has been done using historical Swiss data.
Tamalak
Posts: 1989
Joined: Fri May 06, 2016 2:29 pm

Re: Inflation adjusted - real return

Post by Tamalak »

Dsc8 wrote: Wed May 25, 2022 2:57 pm
FiveK wrote: Tue May 24, 2022 6:02 pm
Dsc8 wrote: Tue May 24, 2022 3:41 pm The point is, SPY gives you a reasonable return after inflation, a 6%, which is way better than VT and does make a difference.
It may be that SPY has been better than VT, but the real point should be what do you expect will be better? Good arguments can be made either way....

E.g., see Callan periodic table of investment returns - Bogleheads.
Thank you for the link, food for thought.

So yeah, it is safer going global. I just don't understand why such players as Buffett and perhaps even Bogle are against going outside US, or it is not true?
Buffett is an active investor. He looks for "wonderful companies at a fair price" in his own words. In order to judge whether a company is wonderful, he has to understand it. He explicitly ignores any investment opportunities outside of his sphere of expertise - and his sphere, by his own judgement, is USA-only (and not even all the USA, only particular sectors).

Bogle is not against investing outside the USA. He has said that it is not necessary and that he does not particularly recommend going over a certain international percentage (I think it was 20%). There is about a 50/50 split on this forum as to whether Bogle is correct to tilt towards USA or whether it's best to buy the "whole haystack" which is VT.
About the magic "25x", is it calculated pre taxes?
Yes. I tend to forget to include that in my own head calculations because taxes for capital gains are pretty low in the USA - in fact they're 0% for the first $40,000. So if half my withdrawals are capital gains and half are "seed money", I could withdraw $80,000 from a brokerage account without incurring any taxes. However, 401(k) distributions are treated as income, and half my savings are in that.. so I should factor that in..

So really, one needs more than 25x. One needs 25x NET of taxes.
Topic Author
Dsc8
Posts: 29
Joined: Sat Apr 23, 2022 6:09 pm

Re: Inflation adjusted - real return

Post by Dsc8 »

Thank you both for the above answers. You did teach me new things and I'm grateful. :sharebeer
Post Reply