The Silent Assassins
Rarely do investors factor in the impact of taxes and inflation on their portfolio returns. Given the current tax rate uncertainty—thank you, Congress—regarding both capital gains and ordinary income, it’s no wonder the typical investor has such a difficult time planning for taxes. But both taxes and inflation matter a lot because your “real” return, or the amount of money you have left over after paying taxes and accounting for inflation, is what pays the bills.
Estimate Your Tax and Inflation Impact
I’ve provided a great chart below, courtesy of Ric Edelman, to help you quantify the amount of portfolio return you need to make just to stay ahead of taxes and inflation. It’s a scary chart given both state and federal taxes are probably, in my humble opinion, going to rise no matter who is in the White House. As for future inflation, who really knows? Medical, college and energy costs are above the long-term average inflation rate of 3.2%, but technology, productivity and cheap global labor keep other inflation items in check for now.
Determine Your Investment Hurdle Rate
In an earlier blog post, I introduced the Portfolio Cost Analyzer (PCA) application to help you determine the impact of advisor fees, fund fees and transaction costs on your portfolio returns.
For example, say your advisor charges you 1.00% per year on assets under management, the expense ratio for all your mutual funds, ETFs and individual stock holdings totals 1.25% and you incur another 0.25% in active trading costs. All that adds up to a 2.50% per year fee drag on your portfolio returns. If you include another 1.00% in hidden opportunity costs, internal fund churn and bid-ask spread loss, your total pre-tax, before-inflation costs average 3.50% per year.
Now include your tax and inflation costs on top of the portfolio fees and it gets truly ugly. For example, if your combined state and federal effective tax rate is 40% and you expect 3.00% annual inflation, then your portfolio must earn at least 5.00% to stay ahead of taxes and inflation. Combine this 5.00% rate with the 3.50% in portfolio fees, and your investment hurdle rate is now 8.50%. This means your portfolio must earn at least 8.50% or more annually to provide you with any real, take-home spending dollars. Koch Capital’s free Household Balance Sheet template, which is available here for those serious about retirement, will help you determine your minimum real return (a.k.a. Discount Rate) that your household asset base needs to generate annually in order to fund your desired retirement lifestyle.
How Lucky Do You Feel?
The figure below is an unsourced, frequency distribution of historical S&P 500 returns by year, overlayed with my crude 8.50% investment hurdle rate line. The investment hurdle rate line divides whether you made real money (green area) in a given year or lost value (red area) to portfolio fees, taxes and inflation.
Past performance is not indicative of future results
Source: Unknown, Koch Capital
If your long-term investment goal is to retire someday, then you need increase the size of the green area in order to reduce the frequency of hanging out in the red area. There are basically two ways to accomplish this. You can move the red fees, taxes and inflation (hurdle rate) line to the left by reducing portfolio costs and taxes. Alternatively, you can increase your average annual portfolio returns so your personal long-term “mean” moves to the right and further away from your hurdle rate line (a.k.a. increase margin of safety). The former requires good financial planning and discipline while the latter requires substantial investment skill and luck, especially with the current high stock market valuations and low interest rates. So if you choose to pursue just the latter strategy, then you need to ask yourself one question—how lucky do you feel?
About Jim Koch
Jim Koch is the Founder and Principal of Koch Capital Management, an independent Registered Investment Advisor (RIA) in the San Francisco Bay Area. He specializes in providing customized financial solutions to individuals, families, trusts and business entities so they are better able to achieve their goals. Jim sees himself as an "implementer" of financial innovation, using state-of-the-art technology to provide practical investment management and retirement planning solutions for clients.
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