I hear investment specialists talk about real returns and nominal returns. But many people don’t know how the difference between a real and a nominal return can make a significant difference on a person’s financial independence.
Many people think about their returns only in nominal terms. That means they only take note of the yield or return on their investment before accounting for inflation. In that view, a 2% bond yields 2%. And a 6% gain on a basket of stocks is a 6% gain.
However, the proceeds of savings and investments are not spent or exchanged in an unchanging world. Every minute of every day, the relative prices of goods and services are changing. In aggregate, they almost always go up over time. That’s what we call inflation.
Inflation is the silent enemy of anyone who is trying to accumulate capital. It continually eats away at the value of one’s savings and investments. It can turn even an investment perceived as safe into a wealth destroyer. Let me explain.
In recent months, investors have been faced with two hurdles: a volatile stock market and a very-low interest-rate environment with yields on bank accounts and money-market funds close to zero.
The market’s roller-coaster ride has caused many investors to pull money out of their stock portfolios and put it into cash. Those who are hunkering down in cash may think they are protecting their nest eggs, but with consumer inflation greater than 3%, savers have actually been losing money that they thought was safe from the stock market’s volatility. If you are earning a nominal return of 0.5% on your money, by the time you subtract an inflation rate of 3.5%, your real return is -3%.
As a result, investors ultimately may lose wealth even as they try to protect it. The loss can come from two sources: the effects of inflation on the purchasing power of your cash and by the loss of opportunity to profit in the market when investors delay reinvesting their money in the market.
Bank deposits and money-market funds are excellent choices for money that will be needed in the near term. But for money which you want to invest over the long term, do not let the daily fluctuations of the markets force you to accept real returns in cash equivalents that will rob you of your ability to maintain your desired standard of living over the long term because you did not keep up with inflation.
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