When my 4-year old daughter wants to make sure that something you’ve said is true, she’ll say, “For real life?” It’s an important question, and it’s been fun watching her try to distinguish between illusion and reality.
I’ve thought about that phrase a lot lately as we’ve seen the various headlines touting brand new all-time highs reached by the S&P 500 Index and Dow Jones Industrial Average.
Last week, the S&P 500 flirted with the highest intra-day level the index has ever reached: when this post was first drafted, the index was at 1,572.91, compared to October, 2007 when it briefly touched 1,576.09. Prior to this month, the two most prominent peaks for the historical monthly closing value of the index appear in July, 2007 (1526.75) and January, 2000 (1498.58).
In fact, if you had invested $100,000 in the S&P 500 Index in January, 2000, your investment would have grown to a little over $132,000 by the end of February, 2013.[i] That equates to an annualized return of 2.14%, despite two epic bear markets. Not great, but at least you made money over a fairly harrowing time period.
Or did you? What’s missing in that equation is the impact of inflation, which we define as the ever-increasing costs of goods and services. Inflation erodes the purchasing power of your dollars: $1 today buys a lot less stuff than it did 13 years ago. And in 2026, $1 will buy a lot less than it does today. Or for easier reference, think about how much it cost to go to the movies 30 years ago ($3.15), or how much a postage stamp cost in 1981 ($0.18).
Over that same time frame of January, 2000 – February, 2013, inflation averaged about 2.47% per year. If you adjust the return of the S&P 500 Index for inflation (in order to figure out the purchasing power of your $100,000 investment), you get a little different story. While you might have ended up with $132,000 in your bank account, that would have bought a little more than $95,000 worth of stuff. In other words, once inflation is factored in, your investment return was actually negative, at about -0.33%/year.
That’s the difference between real and nominal amounts. Your nominal amount is the amount of money you have in the bank or your brokerage account. The real value of those accounts, however, adjusts for inflation to indicate your true purchasing power (using some previous date as a baseline).
A number of retirement projections illustrate some sort of terminal portfolio value (i.e., the amount of money you have when you die). It’s important to distinguish if that terminal value is in future dollars (which would be a nominal amount) or in current dollars (which would be a real amount). At the end of the day, it’s your real dollars and your real investment return (net of inflation) that matters.
While the investment examples here have dealt with the stock market, those are backward looking examples. Going forward, the bigger looming threat is the impact that inflation will have on real returns of bonds. Right now, a 10-year Treasury bond yields about 1.87%. If inflation averages 2%/year over the next 10 years, even though investors will have receive nominal interest payments from their bonds and a nominal return of their principal, both the interest and principal will be guaranteed to have less real value.
That’s not to say that bonds don’t have a place in some portfolios. They still serve to cushion some of the ups-and-downs of the stock market. At Woodward Financial Advisors, we believe that a low-cost, broadly diversified portfolio of different types of stocks, bonds and other assets gives our clients the best chance of both growing their real portfolios and achieving their real financial goals. For real life.
[i] Investors cannot invest directly in an index.