Talking Cash: The unreal problems of real returns
Sometimes I'm surfing the web
and I see these advertisements
from various online banks promoting
their "high interest" savings
accounts, with interest rates at 2 or
2.5 per cent. Don't get me wrong.
Two per cent is a pretty good interest
rate these days for a savings
account or even a GIC. But historically
speaking, it's a terrible interest
rate. It's so bad, in fact, that the
real return on your investment may
be negative.
Real return refers to how much interest you are collecting minus inflation. Inflation is the percentage each year by which goods and services get more expensive. It's calculated and maintained by the Bank of Canada. Inflation for the past 12 months has been about 2.9 per cent. That means something you would have bought a year ago would cost 2.9 per cent more now. Or, in other words, compared to a year ago, your money is now worth 2.9 per cent less.
When figuring out how much money your investment made, you need to factor inflation into your calculation, that way you know your investment's real rate of return. Using 2 per cent as an example, if inflation was 2.9 per cent over the past year and during that year you earned 2 per cent on your money, your real rate of return is -0.9 per cent. No, that negative is not a typo. You actually lost 0.9 per cent by earning 2 per cent interest.
It gets worse. Throw in taxes. If your investment is not tax sheltered, you pay taxes on your interest income, even if the real return is negative. Let's say your marginal tax rate for both federal and provincial taxes combined is 20.05 per cent and you earned $20 interest over a year on a $1,000 investment. You would pay $4.01 in taxes (calculated as 0.2005 x $20). So, before inflation, your return is $15.99. Now, add in sky-high inflation of 2.9 per cent and you've lost even more money.
There isn't much you can do about inflation. It's like bad weather. But you should have your investments in tax sheltered vehicles like RRSPs and TFSAs to avoid pointless taxes. And although there is a lot of fear, particularly among younger people, about getting into stocks, bonds and mutual funds, you have to invest in these products if you want a positive real rate of return. By putting all of your investments in accounts that offer negative real rates of return, you're losing money, albeit just more slowly than if you stuck your money under the mattress.
The best advice is to be a savvy investor and do your research. Try to ignore the fluff of advertisements and look for concrete stats on investment returns. Probably the best advice you'll get as a student is, when you graduate, speak to a certified financial planner. As a student, besides educating yourself, I don't think there's anything you can do that would help you more with your personal finances.
Jeremy Wall is studying Professional Financial Services at Fanshawe College. He holds an Honours Bachelor of Arts from the University of Western Ontario.
Real return refers to how much interest you are collecting minus inflation. Inflation is the percentage each year by which goods and services get more expensive. It's calculated and maintained by the Bank of Canada. Inflation for the past 12 months has been about 2.9 per cent. That means something you would have bought a year ago would cost 2.9 per cent more now. Or, in other words, compared to a year ago, your money is now worth 2.9 per cent less.
When figuring out how much money your investment made, you need to factor inflation into your calculation, that way you know your investment's real rate of return. Using 2 per cent as an example, if inflation was 2.9 per cent over the past year and during that year you earned 2 per cent on your money, your real rate of return is -0.9 per cent. No, that negative is not a typo. You actually lost 0.9 per cent by earning 2 per cent interest.
It gets worse. Throw in taxes. If your investment is not tax sheltered, you pay taxes on your interest income, even if the real return is negative. Let's say your marginal tax rate for both federal and provincial taxes combined is 20.05 per cent and you earned $20 interest over a year on a $1,000 investment. You would pay $4.01 in taxes (calculated as 0.2005 x $20). So, before inflation, your return is $15.99. Now, add in sky-high inflation of 2.9 per cent and you've lost even more money.
There isn't much you can do about inflation. It's like bad weather. But you should have your investments in tax sheltered vehicles like RRSPs and TFSAs to avoid pointless taxes. And although there is a lot of fear, particularly among younger people, about getting into stocks, bonds and mutual funds, you have to invest in these products if you want a positive real rate of return. By putting all of your investments in accounts that offer negative real rates of return, you're losing money, albeit just more slowly than if you stuck your money under the mattress.
The best advice is to be a savvy investor and do your research. Try to ignore the fluff of advertisements and look for concrete stats on investment returns. Probably the best advice you'll get as a student is, when you graduate, speak to a certified financial planner. As a student, besides educating yourself, I don't think there's anything you can do that would help you more with your personal finances.
Jeremy Wall is studying Professional Financial Services at Fanshawe College. He holds an Honours Bachelor of Arts from the University of Western Ontario.
