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Inflation and the Real Rate of Return

Let’s talk about the elephant in the room. Costs of goods and services have gone up. You feel it at the grocery store, gas station and heaven help you if need a piece of lumber or a yard of concrete. You are not alone in the effect of inflation on your monthly budget. Every person along with businesses, large and small, are all impacted. The Labor Department reported that consumer prices were up 7% in December 2021 compared to the previous December.

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.

The chart below shows the Real Rate of Return using the Yield on a 10-Year Treasury Note as a point of reference.  It combines the yield on a 10-Year Treasury Note and the Consumer Price Index (CPI).  The change in the CPI is how economists measure inflation.

Last year the number came in at a huge -5.5%.

When you compare 2021’s inflation to recent history, the next highest year was 3% in 2011. Because there was yield to be had in fixed income, you were only losing money at a rate of -1.1% if you weren’t invested wisely.  (1.9% Yield-3% Inflation= -1.1% Real Rate)

Source: Bloomberg. Past performance is no guarantee of future results. 
10 Year T-Note Yields are rounded. CPI rates are measured year-over-year and are not seasonally adjusted.

Inflation doesn’t only impact your purchasing power; it plays a role in the performance of your investments and the total return of your portfolio. 

So if inflation rises at a rate of 7%, does that mean any investment with less than a 7% rate of return is losing purchasing power?

That’s where it gets a little complicated.

In theory, any investment with less than a 7% 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 there broader market changes at play?

In the end, the real rate of return is only one factor to consider when building a portfolio. Your time horizon, risk tolerance, goals, and liquidity needs are the primary drivers. At the foundation of all of our clients’ portfolios are good quality individual securities. At TruNorth, we understand the market conditions and our investment strategies factor in inflation and the purchasing power of your money.

This Market View was published January 2022.