Wednesday, September 29, 2010

Rat-e of Return & Me Inflation

It’s not how much you make, but how much you keep after tax, after ‘me inflation’ (or ‘me deflation) (1), risk adjusted (with the least nerve racking fluctuation ‘volatility’) to make each particular personal financial life goal.

The rest, as Rabbi Hillel would say, ‘is commentary. Go study.’

Instead, be it for external comparative validation or just ‘let me cut off my brother’s head so I can be taller,’ joining the Rat-e of Return race is for rats.
Inflation or better termed ‘me inflation’ (of deflation -me deflation) differs with each goal, your income status, and age in life cycle) ll as ‘me deflation.’
Do you really give a rat’es ass to beat the Dow if you meet your goal – and with less volatility? If yes, why- and take a minute to call your shrinks, others talk to yourself and kvell.

After Tax Rate/Rape of Return

As of today, the maximum long term capital gains and dividend tax rate is 15% (assuming you are not into the alternative minimum tax). The maximum marginal income tax rate on wages, short term gains, interest and other ordinary income (not sheltered by depreciation, depletion etc.) is not just 36% but closer to 38%+ given phase out of certain deductions at specified adjusted gross income precipices.
State taxes aside, on the same 10% gross rate of return before taxes, long term capital gains nets 8.5% whereas wages, interest, short term gains at the maximum rate nets 6.4% to 6.6% a 22%-24% net after tax difference in rate of return. (Discussions of the advisability of taxing capital and passive income sources differently than income is an aside. However, remember, long term capital gains and dividend preferred taxation – is not preferential – as there is double taxation involving these sources.)

Inflation adjusted Rate of Return

I gotta be me, I gotta be me, who else can I be than what I am?
Sammy Davis, Jr. “I Gotta Be Me”

Now let’s assume in the above example of 10% gross rate of return, 8.5% after tax return if derived from long term capital gains and dividends, 6.4% if derived from other sources of income, general inflation is 3%. The net rate of return drops respectively to 5.5% and 3.4%.
But WAIT, as the infomercials implore us – inflation is not inflation is not inflation. One’s inflation rate is dependent on:

· income level,
· where you are in the life cycle
· the particular goal in question

Thus, each of us has an overall ‘me inflation’ overall as well as a ‘me inflation’ relative to each goal.
A 60 year old married couple making $150,000 with their kids college education costs out of the way (and the kids finally having self supporting jobs after too long of a boomerang back to their house and food ticket) and no longer with mortgage or those durable good purchases facing them – has an overall ‘me inflation’ rate different than even a 30 year old married couple making $150,000 with two kids, saving for college, with a mortgage, and paying off student loans.
If the consumer price index of inflation is 3% overall, the overall ‘me inflation’ might be 1% (except for health insurance) for the 60 year old couple but 5%+ for 30 year olds!
More importantly, me inflation differs per goal.
Higher education costs (personal financial ebola because it cannibalizes, castrates and or defers the work free retirement due primarily to tenured unaccountable condescending Scholar Barons on the Honor Dole – another discussion) has been running 250% to as high as 400% over the consumer price index of inflation. Long term care costs (nursing homes, assisted home care) has even exceeded the education ‘me inflation’ rate – compounding at one point by over 9% (400% over inflation in some recent years.)
Back to our example of 5.5% and 3.4% after tax:
Given a higher education ‘me inflation’ rate of 6% - there would be a negative after tax after inflation rate of -.5% to -2.6% given the income is derived from ordinary sources (wages, interest, ordinary income, short term gains).
Isn’t that comforting, Bunkie, as you write out those tuition checks and wonder will you be a greeter at Walmart to make ends meet?

For whom does the inflation rate bell toll?
For ‘Thee’s Inflation’ (per goal) – not The Inflation.

Risk Adjusted After Tax After Inflation Rate of Return

That’s okay in practice but how doe it work in theory?
The French

Reality, not theory, is that it is volatility/fluctuation which is equated with risk (be it measurements such as beta, standard deviation etc.).
And fluctuation/volatility is nerve racking on the downside to most.
We have a risk capacity and it is related to:

· fluctuation (volatility) which rightly or wrongly becomes synonymous with ‘risk’
· the proximity to the timing of the goal – the closer to the objective the lower the risk capacity

In theory, risk capacity should be related to probability(P) and magnitude (M) or (PxM) but in reality, those are just words when the fluctuation hits the fans.

Nothing kills rates of return – on the ground, in the trenches – than fluctuation. Proof: Dalbar’s study of investor rates of return versus the S&P showed that the average equity investor earned 1.87%/yr. (overall inflation during the period was 2.89% a year) which the S&P index averaged 8.35%. The average bond investor earned .77% versus 7.43% for the index during the same period.
Furthermore, the rate of return of investors in mutual funds has lagged the rate of return of the mutual funds they are invested in.
The reason: investment returns are far more dependent on investor behavior than the fund/index performance. Thus: risk capacity is a behavioral function.
And people (especially those without a grip on the after tax, after inflation, risk adjusted required rate of return they need to meet the goal) regardless of their chest pounding bravado about their ‘risk tolerance’ hate fluctuation/volatility and equate it with loss. (And remember risk is really the chance/probability of not making the goal!)

So what do – recognizing fluctuation is a risk proxy in reality and remembering ‘the flaw of averages’ and ‘Monte Carlo probability analysis’ from previous sections?
In light of the fluctuation/risk equivalency (rational or not), beta – better yet ‘return on beta’ is a useful tool (1)

Beta, a measure of volatility, is the ratio of a stock or mutual fund’s fluctuation compared to an appropriate benchmark index (i.e. the S&P 500).
Let’s say you require after tax, after inflation, a 4% real rate of return (pretax rate of return 10%, after tax 8% and after inflation 4% yielding a 4% real rate of return). Now Mutual Fund A which you are considering had a rate of return, for argument’s sake, of 12% with a ‘beta’ of 50% when the market was up 12%! The return on beta is 24% (12%/.5%). You would have made 12% (all things being equal) with ‘half the volatility/risk’ of the index (in this case representing the US Stock Market). Goal for the year accomplished after tax, after inflation risk adjusted (12%x.8 tax rate ((inverse of tax rate of 20%))-inflation 4% = 5.6%. The risk adjusted return on beta after tax and inflation is 11.2%!
Fund B, in the same year, did 24% outperforming the index by 12% and made the goal after tax, and after inflation (24%*.8 ((inverse of tax rate)) -4% = 15.2% outperforming fund A. But did it when considering volatility/risk? Given a 300% beta, the rate of return after tax and inflation is 15.2% outperforms the index and fund A. But then when the after tax after inflation rate of return has beta applied the 15.2% becomes 5.06%. Now think, if instead of 24%, the rate of return, the return for Fund B was 16% with a 300% beta – the rate of return on beta becomes 2.93%. Thus, the goal adjusted for ‘risk’ is not made.
Is the heartburn worth it?
More demonstrable is applying rate of return on beta to the gross rates of return. At 12%, Fund A had a return on beta of 24% (24%/.5) whereas Fund B had a return on beta of 8% (24%/3.00).

However, none of this return on beta matters – if the rate of return after tax and inflation isn’t met – given the same present funding levels of the goal per year..
Please remember, return on beta is just a financial tool – and unlike Sears Craftsman tools, it does not come with a lifetime guarantee.

Now could there be an instance where, despite a lower return on beta, one can go for the higher rate of return? Yes (though typically not advised) where the client has a low personal beta.
What the heck is a personal beta?
A gastroenterologist’s income is more stable – varying little with the economy (though moreso with the increasing or decreasing demographic of 50 years old+ individuals who will require colonoscopies every 5 or 10 years. (It is reputed that gastroenterologists believe they are in a ‘sh*tty business’ and ‘love it.’). In contrast, a big ticket commercial real estate developers’ income have a high probability of varying widely with the economy. The gastroenterologists have a low personal betas from which income can more reliably go to fund their goals year in and year out in contrast to the big ticket commercial real estate developers whose income fluctuates (thus having a high personal beta) moreso with the general economy. As a result of the cushion of the low personal beta, the gastroenterologists have the cushion/tushion (though not advisable in most cases) to go for a higher nominal rate of return even if those investments result in a lower return on beta. The scenario for the gastroenterologists taking ‘higher risk’ for ‘greater nominal though lower return on beta’ returns would be that for some reason (divorce etc.) the gastroenteologists cannot maintain the funding level necessary in some year or two and the objective is 10+ years in the future.

Finally, the other risk measure is the probability of funding the goal. Some planners use 80%, others require 90% and still others 95% probability using Monte Carlo analysis previously discussed. Be aware that relative to asset accumulation goals (education, slow down, retirement etc.) the higher the probability required, the ‘more’ assets required (an Assets under Management compensation financial planner’s dream come true annuity). And even at the 95% probability level, there is the possibility of the Black Swan like in 2008.

Next: Constraints, Criteria & Other Ground Rules

(1) For purposes of this commentary, inflation is being assumed rather than the more rare over time deflation – spousal me deflation of one’s character and value is a different question
(2) others may prefer tools like standard deviation which asses the the extent to which a portfolio return differs from the mean. Still others like r2 or downside risk DVR measures.

No comments:

Post a Comment