Does this sound familiar? An investor has a good year in the stock market and meets with his financial advisor to review his performance. The message from the advisor is clear: “Your portfolio returned 9%.”
That is a great year by most standards. In the back of investors’ minds, they also know they pay a 1.5% annual management fee, which is simply deducted from the account and is part of the process.
A few months later (usually in February), the client receives a 1099 from the investment custodian in the mail for taxes due on the investment return. The taxes are more than they expected. It triggers a thought…“Was it really 9%?”
From a typical perspective, the answer is yes.
The starting and ending values aligned with what the client had been told. But if we look at our money decisions from a macroeconomic perspective, we go beyond the surface-level results. The answer turns out to be quite different.
If we account only for the management fee and taxes, the real rate of return was closer to 5.5%. If you dive even deeper, the story gets worse because you lost the money you used to pay the tax, and what you could have done with that money. In economic terms, this is called lost opportunity costs. When we lose a dollar and what we could have done with that dollar, the cost goes on forever.
This experience is a great example of the adage “It’s not what you earn, it’s what you keep.” There are layers to every investment decision. What was the stated rate of return? What was the return after fees? What was the net rate of return after taxes and any additional costs?
The decision should also be analyzed for its effectiveness in the three phases of money.
- How successful will this investment perform during the accumulation phase (The time I am trying to build up my net wealth)?
- How will it perform during the distribution phase (this is the time in life when I want to enjoy the wealth I accumulated).
- How will this investment perform when I want to preserve its value and pass it on to the next generation of my family?
Actual rate of return is different from the actual rate of return. A person may think in terms of compound interest when they are told they receive a 9% rate of return.
But you cannot receive a compounded rate of return in an account that goes up and down in value. Volatility creates a hidden cost. A person could have three investments with identical costs and rates of return, but different levels of volatility.
At the end of the year, each account will have different account values, but the average rate of return was identical. The account with the lowest volatility will have the most money in it. Macro-economic decisions lead to better results than micro-economic decisions.
Securities and investment advisory services offered through Hornor, Townsend & Kent, LLC (HTK), Registered Investment Adviser, Member FINRA/SIPC. 800-873-7637, www.htk.com. Wealth Coordination Partners is unaffiliated with Hornor, Townsend & Kent, LLC. The views expressed are those of the presenting party and may not necessarily represent those of HTK or its affiliates. The material is not intended to be a recommendation, offer or solicitation. HTK does not provide legal and tax advice. Always consult a qualified tax advisor regarding your personal situation and a qualified legal professional for your personal estate. 8647224DH_DEC27
