A colleague once told me about the amazing 10% interest she was getting in her home country’s savings account. My first inclination was to ask her what the inflation rate was in her home country and it turned out to be around 8%, meaning she was earning 2% in real interest – not bad, but nowhere near the 10% excitement level. Despite seemingly large differences in cost of living and interest rates, there’s a lot of consistency all around the world. Here’s how to account for the effects which distort your real returns.
Inflation reflects rising prices, which means the same item will cost a little more next year, and again the year after that. If you don’t put your money into an interest earning banking account, each year you won’t be able to buy as many things. In effect your money is worth less and you lose purchasing power. So, whatever interest rate you get, you need to subtract out inflation to see if you really earned interest, lost money, or if you just kept pace with inflation.
The same concept applies to investing. When people say the stock market earns 8-10% returns a year, they are likely saying that your investment will grow, on average, 10% a year, but with inflation, it is really growing 8% a year. When comparing the 8% to other rules of thumb such as the “4% rule” (retire when you can live off 4% dividends from your investments), be mindful that they may not be factoring in inflation (it should really be the “6% rule”, but that’s a lot harder to achieve without some risk).
Differences in inflation rates across countries contributes to changes in exchange rates too so like in the case with my colleague’s savings account, don’t be fooled by these conversions. Fortunately, you can simply convert all the numbers to one currency, but make sure to use the right date’s exchange rates.
Whether you have your money in a savings account, retirement funds or more exotic foreign holdings, it’s important to evaluate them based on real returns, which means adjusting for inflation and converting to one consistent currency.