Making a simple profit in investing isn’t enough.
You need to make profits that are bigger than a certain level. That is, if you want your wealth to keep its value when converted into things.
After all, wealth is no use in itself. It’s the ability to convert it at a future date into things that you need and want that gives it value. It could be a bigger house you have your eye on…or a better car…or taking time to travel around the world…or just providing for your needs in retirement.
So what is the level of profit that is “enough”? Well, it depends on your own circumstances. The most important of those is usually where you live and where you plan to live in future. This is because where you live determines how much and what type of tax you pay. And also how much prices are going up in local currency terms, a phenomenon usually known as “inflation”.
To keep the value of your wealth you need to beat both taxes and inflation, after paying all investment costs. Only once you have achieved this are you making a real profit on your investments. (In fact many people, including me, consider price inflation to just be another government tax. So in that sense successful investing is all about staying ahead of what the government is trying to seize from you.)
…if you aren’t matching taxes and inflation on average, over the long run, then you will be falling behind in terms of your wealth.
Of course any profit is better than none. And you don’t need to have high profits every single year of your investment life. But if you aren’t matching taxes and inflation on average, over the long run, then you will be falling behind in terms of your wealth. By which I mean that as time moves on your wealth will be convertible into fewer and fewer things that you may wish to use or consume.
Taxes vary significantly by country…both in type and in amount. The most usual taxes faced by private investors are two-fold.
Income tax is charged on cash income that you receive each year. This includes items such as dividends from stocks and shares, coupon interest from bonds, and rental income from property (real estate).
Capital gains tax is charged when you sell an investment, and is applied to the difference between what you paid when you bought and what you received when you sold.
Some countries also have wealth taxes, which are charged each year as a percentage of the value of your assets, even if there are no investment profits. And many countries have death taxes, also known as inheritance or estate taxes, which are charged on the value of your assets when you die. Death taxes may not affect you directly, but can seriously reduce the amount of wealth that you pass on to your children (or other heirs).
Beating taxes and inflation makes for an investment challenge that can seem daunting. But our aim at OfWealth is to show you how it is achievable.
For now let me just show you the size of the challenge to make a real profit by way of example.
For simplicity let’s assume we’re only affected by income and capital gains taxes. The rates are usually different for these taxes – often higher for income and lower for capital gains. Let’s assume income tax is charged at 40% and capital gains are taxed at 20% – which are fairly typical rates. And also that our gross profits come equally from income and capital gains, meaning the average tax rate is 30%. Put another way, we get to keep 70% of the gross profits.
Now let’s assume that consumer price inflation is 5% (this will vary a lot depending on your country). And also that we pay 1% a year in fees and commissions on our investment accounts (you’d be surprised how it can add up…).
To beat taxes and inflation we can calculate that we need to make about 7.14% a year of profit, made up of capital gains and income (5% divided by 70%). Add in the 1% of fees and commissions and we need to make 8.14% gross profit just to stand still.
Looking at it the other way around, 8.14% less the 1% of investment costs is 7.14%. Take away 30% in taxes and we’re left with 5% net profit. This is just enough to match inflation in this example. In other words it’s enough to keep the buying power of our investments in line with consumer price increases.
This is a reasonable example, using typical tax and inflation rates. And yet standard financial investment strategies would struggle to achieve this kind of gross return, somewhere above 8%.
The higher the tax and inflation rates, the harder it will be to keep up. To achieve the aim of preserving wealth in inflation-adjusted terms, let alone growing it, it’s essential to have an investment strategy that improves the chances of large, long term profits.
Here at OfWealth we aim to help you to achieve that goal.
Until next time OfWealthers,