The media and investors often focus on nominal returns when discussing how a particular stock index performs. For example, recent headlines have touted the fact that the S&P500 rose 13.7% in 2014. Yet, this nominal return doesn’t take into account such factors as expenses (what you pay an investment management firm if you own a mutual fund), taxes (you pay Uncle Sam for capital gains as well as dividends) and inflation (the rise in the price level of things we purchase).
The chart below shows how the value of a $100 investment in the S&P500 in 1983 grew over a 30 year to $2,346 on a nominal basis. After taking into account the costs described above, that $2,346 is whittled down to $570 (Hat tip to Business Insider).
- As an investor, you can control expenses (by choosing low expense index funds) and capital gain taxes (you pay these taxes on the gains from selling your investment so if you can defer these taxes until you sell). Note that some mutual funds generate capital gains within their portfolios which investors ultimately pay even if they don’t sell their investment.
- Unfortunately with inflation and taxes on dividends, you have less control. The reason inflation needs to be considered is if you choose less risky strategies (put money in a savings account), you may have trouble keeping up with inflation, which inexorably rolls on.