Saturday, January 12, 2013

Rate of Return (ROI) vs. Inflation

I set my goal back in 2010 that I would need $2 million to become a financially independent person. This means that I have enough capital to generate income which should cover my expenses.

I looked at the role of the inflation on my portfolio. Since the 2010 Cumulative inflation over 3 years is 9%.  In practical terms  it converts $100 in 2010 worth less than $92 today.  If current inflation rate will stay the same by 2040 the same $100 would worth only $48.

I reported that my portfolio worth $226,800 but in 2010 money it is $209,000. This underlines importance why  rate of return on your investments should be at least 2-3% above inflation rate.

Lets run a scenario with following assumptions :
- Inflation rate 4% a year.
- Annual Investment Savings rate start at $42,000 and go up by 5% a year or 1% above inflation.
- Rate of Return (ROI) on investments 2% above inflation.

In 2040 this would present:
- Annual Investment Savings of $135,454 or $65,000 inflation adjusted (after 27 years at 1%).
- Net Worth $5,517,000 or $2,646,000 inflation adjusted.
I need to pay attention to both - rate of return and inflation. Only this two figures together can tell the story. For example, a company continuously increase  dividends pay outs year after year. It should be no surprise. What we need to look at - inflation adjusted results.  Historically inflation was in two digits for years, so no wonder principals are growing relatively fast.

1 comment:

  1. $2.6 million in today's dollars in 2040 wouldn't be so bad :) I hope I will have at least 2 million 2013 dollars by then. That puts inflation in line with historical patterns. $1 thirty years ago is only worth about 50 cents today. Every 3 decades, money loses half it's value.