Inflation can have a large impact on your investment, so it is important to understand how that works. Let’s say you have cash and save it by hiding it in your mattress. Your money gets less valuable every day by exactly the rate of inflation because money is something we need to buy goods and services. If you hide your savings in a mattress and the rate of inflation is 2%, your money is depreciating in value by 2% per year. The same thing happens to money you keep in a checking account that pays no interest. Your money is depreciating at a rate of 2% per year. Even further, the money you receive as a dividend or interest on your investment is also depreciating at the annual rate of inflation. The real quest, then, is to find an investment that gives a return greater than the rate of inflation.
In order to be able to compare the return on all sorts of different investments, like buying stocks or buying a Picasso, we use the same measure to calculate returns. The return on an investment comes from two areas: dividends or interest paid and the price appreciation. For example, you may put your savings in stocks and get a dividend of 2% per year plus the stock price may have increased by 8% over the course of a year. Thus, your total return for that year would be 2% + 8% = 10%. Alternatively, those investors who buy gold or a Picasso do not get any interest or dividends but receive returns from the price appreciation of their asset over time. If you bought gold today at $1,600.00 per ounce and after a year its price was $1,700.00 per ounce, your annual return would be:
The general calculation of a return on investment (ROI) is the appreciation in the price (value) of the investment (asset) over a year plus any dividends or interest earned during that year, compared to the original cost of the investment (asset). The calculation is thus:
This calculation will yield a decimal which is then expressed as a percent annual return. The general formula is expressed as a backward-looking calculation:
Now, here’s an example. Let’s say you purchase 100 shares of Apple stock at $5.00 per share. At the end of one year, it is now selling on the stock market for $6.00 per share. In addition, you receive a dividend of $1.00 from Apple during the year. Your return could be expressed like this:
If your investment is held for multiple years, you would use the total price appreciation of the asset plus add up all the dividends and calculate your total return. You would then divide the total return by the number of years you held the asset to get the average annual return. This annual return allows investors to compare the annual returns for all sorts of investments that are dissimilar, such as paintings, antique automobiles, collectibles, and stocks and bonds.
However, there is one more complication to consider: taxes on your profits from investments. The profit you make from the price appreciation of an asset is called a capital gain, and it is taxed when you sell the asset to realize the gain. Taxation of the capital gain is different if you own the asset for less than one year (a short-term capital gain) or own it for more than one year (a long-term capital gain). A short-term capital gain is just added to your regular income on your tax return and taxed at your regular income tax rate. On the other hand, if you sell the asset after owning it for more than one year, you will be taxed at the long-term capital gains rate. If your total taxable income is $39,375 or below, a single person will pay 0% capital gains tax. If their income is $39,376 to $434,550, they will pay a 15% capital gains tax. Above that level, the rate jumps to 20%. The tax rates (or brackets) are somewhat different for married people. Tax laws give an incentive to hold investments over one year.