1/ Get a cup of coffee. In this thread, I'll help you understand the relationships between *investing* and *inflation*.
2/ In his 2011 letter to Berkshire shareholders, Warren Buffett made an important observation. He said that the purpose of investing is not just to grow *money*, but to grow *after tax purchasing power*.
3/ This means: Investments should not be evaluated simply in *nominal* terms -- how much they grow our money. They should be evaluated in *real* terms -- taking into account both taxes and inflation.
4/ Let's take an example. Suppose we invested $100K in a stock 5 years ago. And suppose the stock doubled in these 5 years. So now, our position is worth $200K. This is a *nominal* annualized return of about 14.87%.
5/ Suppose we now sell the stock. When we sell, we have to pay *capital gains tax* on our $100K profit. Let's say our tax rate is 20%. So we'll pay $20K in taxes. After that, we'll have $200K - $20K = $180K left over.
6/ But as Buffett said, that's not all. We should also consider *inflation*. Let's say, over the last 5 years, inflation was about 5% per year. That means, we need $1*(1.05^5) = $1.28 today to buy the same goods and services that $1 would have bought us 5 years ago.
7/ So, the $180K we have today is equivalent to about $180K/1.28 = $141K in "5 years ago" money. So, in *constant dollar* terms, we've grown $100K into ~$141K over 5 years. This is a *real* annualized return of only ~7.12% -- much worse than our *nominal* ~14.87%.
8/ Also note: capital gains tax reduced our gains by $20K. But *inflation* further reduced them by about $180K - $141K = $39K. So, the impact of inflation was almost *twice* as bad as capital gains tax. In his 2011 letter, Buffett called this the "invisible inflation tax".
9/ But inflation was only 5%. Capital gains tax was 20%. And yet, inflation had the bigger impact. Why? There are 2 reasons.
10/ First, inflation *compounds* year over year, whereas capital gains tax is paid *just once* -- at the end when the stock is sold. Second, inflation erodes the *entire capital* (principal + profits), whereas capital gains tax is levied *only on the profits*.
11/ Here's a formula to calculate the *real* annualized return -- accounting for both inflation and taxes -- from the *nominal* annualized return of an investment:
12/ Carrying this one step further: The same principles also apply when a company *reinvests* its earnings back into its own business -- instead of distributing these earnings to shareholders as dividends.
13/ The reason why companies retain earnings: they believe that for every dollar retained and reinvested back into growing the business, they will *eventually* be able to distribute more than $1 of value to shareholders.
14/ For example, let's say a company we own earned $1 this year (after tax). The company could, of course, distribute this $1 to us as a dividend. If the company did this, we'd pay, say, $0.20 in income taxes and be left with $0.80 of "purchasing power".
15/ But instead of this dividend, let's say the company retained this $1 and used it to buy an asset. Let's say this asset will last 10 years, and will generate $0.30 of cash in each of those 10 years. That's a pre-tax return (IRR) of ~27.32%. For more:
16/ The company can claim a $0.10 per year depreciation charge for this $1 asset over the next 10 years. So, its pre-tax income from this asset will be $0.30 - $0.10 = $0.20. For more:
17/ Let's say the company pays a 25% tax on this $0.20 of pre-tax income. That's a $0.05 tax bill. This leaves $0.30 - $0.05 = $0.25 in operating cash flows -- every year for the next 10 years. Suppose the company distributes all these cash flows to us as dividends.
18/ Of course, we then have to pay our 20% income tax on these dividends, netting us $0.20 each year over the next 10 years. See, we have 2 layers of taxation -- one at the corporate level and one at the shareholder level!
19/ Also, unfortunately, we have 5% inflation. So, the first $0.20 will only be worth $0.20/1.05 = ~$0.19 in today's dollars, the second $0.20 only $0.20/(1.05^2) = ~$0.18, and so on -- up to the tenth and final $0.20 that will be worth only $0.20/(1.05^10) = ~$0.12.
20/ So, in *real* terms, we gave up $0.80 of purchasing power when the company decided to retain the original $1 instead of paying us a dividend. But in return, we get this sequence of diminishing inflation-adjusted $0.20 payouts for 10 years.
21/ Therefore, our *real* return from $1 of earnings retained by the company -- considering both the purchasing power given up and that obtained in exchange -- works out to about ~15.63%.
22/ This ~15.63% in our hands is, of course, much lower than the ~27.32% originally earned by the company on the asset. But that's what 2 layers of taxation combined with inflation can do.
23/ Key lesson: it's vitally important to account for both taxes and inflation while analyzing investment returns -- from both stock purchases/sales and dividends/retained earnings. What counts is the preservation and growth of *real* purchasing power, not *nominal* dollars.
24/ I also want to mention why I used 5% for inflation in the examples above -- when it's no secret that the Fed aims to keep it at ~2%. The reason has to do with the way inflation is measured -- Consumer Price Index or CPI.
25/ Our actual costs of living tend to rise a bit faster than CPI. This is because CPI relies on assumptions like "substitution": if a product becomes pricey, CPI assumes that we'll substitute it with a cheaper product, which we may be unwilling to do.
26/ Also, CPI adjusts for "quality". For example, cars have become more expensive over time. But they've also improved in safety, fuel efficiency, and performance.
27/ So, CPI tries to only reflect *part* of a car's price increase -- the part that's due to general inflation. The rest of the price increase is attributed to product improvements -- and excluded from CPI.
28/ But of course, when we buy a new car, we're hit by the *full* price increase -- not just the part that's reflected in CPI. Also, over time, we all experience "lifestyle creep" -- we consume more goods and services over time. This is not reflected in CPI.
29/ For all these reasons, it's a good idea to be *conservative* with inflation assumptions. If our portfolio can deliver growth in purchasing power even at 5% inflation, then we're likely to do even better if inflation turns out to be only 2%. But the reverse isn't true.
30/ In addition to Buffett's 2011 letter above, I also recommend reading his 1980 letter. This was written when inflation was rampant in the US (close to 15% per year). And as always, Buffett's thoughts are clear-headed and beautifully expressed. Link:
berkshirehathaway.com/letters/1980.h…
31/ Also, thanks to @rationalwalk and @RudyHavenstein, I stumbled upon this comic book about inflation -- created by the Federal Reserve Bank of New York. It's a super fun read! Link:
ia600307.us.archive.org/26/items/gov.f…
32/ Finally, my friend @SahilBloom has also created a very nice thread explaining the basics of inflation:
33/ If you're still with me, thank you! It's the season of gratitude -- and I feel especially blessed to have readers like you. Have a great Thanksgiving weekend! /End
