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The idea that it is necessary to achieve a 15% return on your investment comes from the mind of Warren Buffet, the single most successful investor. This is a man who adopted the idea of investing from a business perspective as his chief strategy.
When you put together taxation and inflation, your return is less than what it appears to be. When you hear that inflation is 3.2%, you would think, "I need at least a 3.2% return each year to increase my buying power". But you must also factor in the taxes. Let's say inflation is at 3.2% and you pay 28% in taxes. This means that you would have to return at least 4.44% (3.2 / 0.72).
However, taxation and inflation have not always remained at these levels. During the early seventies when the economy was inflated to cover the costs of the Vietnam war, inflation rose to 9% and the tax rate was almost 40%. And under these circumstances, a 15% return is required just to equal the taxation and inflation (9 / 0.6). That is how Warren Buffet's idea of the 15% comes in.
In the past, many countries including the United States have seen inflation in the double-digits and personal taxes have reached 50%, but it is nearly impossible to predict such occurrences in the long-term so a 15% return would most likely be enough to keep you "safe" from inflation and taxation spikes. The historical average for inflation is 3-4% and if taxes remain the same, a 15% return is excellent and will increase the value of your portfolio greatly over time even with taxation and inflation factored in.
Investing in stocks and mutual funds is a great way to keep your money safe from rising taxes and inflation. Indices like the S&P 500 have returned an average of 13% over the last 30 years and there are many great index funds that match the S&P's returns. By investing, not only will you be keeping your money relatively safe from inflation, you will also help your money grow and over time it can add up greatly!
As we discussed last week, inflation is a factor that hurts an investor's actual return. Taxation is also another factor that diminishes the return on your investment. When you sell stock, you have to pay taxes on your capital gains which can be as high as 40% (but varies based on your income tax). This means that if you achieve a 10% return, essentially 4% of it is lost in taxes. Let's say you just got excited over making $10,000 on that stock you were following. Well, before you plan to buy that new stereo and wide-screen television, you must understand that you are responsible for paying $4,000 of that money in taxes.
Chris is the publisher of TeenAnalyst.com, a site that helps teach and encourage young
adults to start investing.
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