Adjusted future total return: Meaning, Criticisms & Real-World Uses

What Is Adjusted Future Total Return?

Adjusted future total return refers to a forward-looking projection of an investment's aggregate return, modified to account for anticipated factors that could erode or enhance its true value over a specified investment horizon. Unlike a simple projected total return, which might only consider anticipated price changes and income, the adjusted future total return typically incorporates the estimated impact of inflation, taxes, and fees. This concept is a crucial tool within investment analysis, providing investors with a more realistic expectation of their future purchasing power. By adjusting for these significant variables, investors can make more informed decisions about asset allocation and strategy, aiming to preserve and grow real wealth.

History and Origin

The concept of adjusting investment returns for factors like inflation gained prominence as investors and economists recognized that nominal gains did not always translate into real increases in wealth. While the precise term "Adjusted Future Total Return" may not have a singular moment of invention, its underlying principles are rooted in long-standing financial theory concerning the time value of money and the impact of inflation. The understanding that inflation erodes purchasing power, making nominal returns misleading, became widely accepted, particularly after periods of high inflation in the 20th century. For instance, the U.S. Federal Reserve began focusing on measuring and managing inflation more actively to maintain economic stability, emphasizing the distinction between nominal and real returns. Calculating a real return on an investment by subtracting the inflation rate from the nominal rate has been a foundational concept in finance for decades.⁴ This historical awareness led to the development of sophisticated methodologies for forecasting and adjusting future returns to reflect real economic outcomes, rather than just monetary figures.

Key Takeaways

Adjusted future total return provides a more realistic estimate of an investment's projected performance by accounting for factors such as inflation, taxes, and fees.
It aids investors in understanding the actual increase in their purchasing power over time.
This metric is essential for long-term financial planning, helping to set appropriate investment goals and strategies.
Unlike simple projected returns, adjusted future total return offers a clearer picture of wealth accumulation after accounting for various eroding forces.
Its accuracy relies heavily on the reliability of assumptions regarding future inflation rates, tax laws, and market conditions.

Formula and Calculation

Calculating an adjusted future total return involves projecting the nominal total return and then modifying it for various factors. While there isn't one universal formula, a common approach for adjusting for inflation, similar to calculating a real return, can be expressed as:

\text{Adjusted Future Total Return} = \left( \frac{1 + \text{Nominal Future Total Return}}{1 + \text{Expected Inflation Rate}} \right) - 1

Where:

Nominal Future Total Return: The anticipated total return of an investment before accounting for inflation, taxes, or fees. This includes expected capital gains and income (e.g., dividends, interest).
Expected Inflation Rate: The anticipated rate at which the general price level of goods and services is expected to rise over the investment period.

Further adjustments for taxes and fees can be incorporated by applying those rates to the nominal or inflation-adjusted return. For example, if taxes on investment income and capital gains are applied, they would reduce the net future return. Similarly, ongoing investment management fees would also subtract from the gross return. The goal is to arrive at a future value that reflects actual purchasing power.

Interpreting the Adjusted Future Total Return

The adjusted future total return provides a crucial lens through which investors can evaluate potential investments. A positive adjusted future total return indicates that the investment is expected to increase an investor's real purchasing power over the investment period, even after accounting for factors like inflation. Conversely, a negative adjusted future total return suggests that the investment might lose real value, despite potentially showing a positive nominal return.

For example, if an investment has a nominal future total return of 7% but the expected inflation rate is 3%, the adjusted future total return would be approximately 3.88%. This figure tells the investor that their real wealth is projected to grow by nearly 4%, not 7%. This perspective is vital for long-term financial planning, ensuring that investment strategies are aligned with goals that account for the eroding effects of inflation on future wealth. Without this adjustment, investors might overestimate their future financial well-being, leading to inadequate savings or misguided risk assessment.

Hypothetical Example

Consider an investor, Sarah, who is evaluating a potential investment that she expects to hold for five years. She projects a nominal total return of 8% per year from this investment, which includes both anticipated price appreciation and dividends. However, Sarah anticipates an average annual inflation rate of 2.5% over her five-year investment horizon.

To calculate the adjusted future total return, Sarah would apply the formula:

Nominal Future Total Return: 8% or 0.08
Expected Inflation Rate: 2.5% or 0.025

\text{Adjusted Future Total Return} = \left( \frac{1 + 0.08}{1 + 0.025} \right) - 1

\text{Adjusted Future Total Return} = \left( \frac{1.08}{1.025} \right) - 1

\text{Adjusted Future Total Return} = 1.0536585 - 1

\text{Adjusted Future Total Return} \approx 0.0536585 \text{ or } 5.37\%

In this scenario, while Sarah's investment is expected to provide an 8% nominal return, her adjusted future total return, after accounting for inflation, is approximately 5.37%. This means that the real purchasing power of her investment is projected to grow by 5.37% annually. This adjusted figure gives Sarah a more realistic understanding of her potential wealth accumulation compared to just looking at the nominal 8%.

Practical Applications

Adjusted future total return is widely applied in various areas of finance and investment planning:

Retirement Planning: Individuals and financial advisors use adjusted future total return to project whether current savings rates and investment strategies will be sufficient to meet future retirement needs, considering the impact of inflation on living costs.
Long-Term Investment Goal Setting: For goals such as funding a child's education or purchasing a major asset, understanding the adjusted future total return helps set realistic targets and determine the necessary contributions to achieve them.
Portfolio Management: Professional portfolio managers use this metric to evaluate the efficacy of different investment vehicles and strategies. They may adjust their diversification or discount rate assumptions to improve the real rate of return.
Economic Analysis: Economists and policymakers monitor inflation-adjusted returns across various asset classes to gauge the health of the economy and the effectiveness of monetary policies. For example, the Federal Reserve frequently analyzes real interest rates as part of its economic assessments.³
Valuation Models: In corporate valuation and financial modeling, adjusted future total returns can be used as inputs for discounting future cash flows, ensuring that the present value accurately reflects future purchasing power.

Limitations and Criticisms

Despite its utility, the adjusted future total return has several limitations. Chief among these is its reliance on forecasts, particularly future economic indicators like inflation rates and tax laws, which are inherently uncertain. Projections, especially over long investment horizons, are susceptible to significant error due to unforeseen economic shifts, geopolitical events, or technological advancements. The Securities and Exchange Commission (SEC) provides guidance on the use of forward-looking statements and projections, emphasizing the need for material bases and assumptions to be disclosed, acknowledging their inherent uncertainty.²

Another criticism stems from the complexity of accurately modeling all relevant adjustments. Beyond inflation and general taxes, specific investment fees, state taxes, and individual tax situations can vary widely, making a precise, universal adjusted future total return difficult to calculate and communicate. Furthermore, market forecasts, in general, are challenging to get right, with many academic studies highlighting the significant noise, nonlinearity, and volatility of stock price data.¹ This unpredictability means that an "adjusted future total return," while providing a better estimate than a nominal one, still carries a degree of speculative uncertainty. Investors must understand that such projections are estimates, not guarantees of portfolio performance.

Adjusted Future Total Return vs. Real Rate of Return

While both adjusted future total return and real rate of return account for the impact of inflation on investment gains, they differ primarily in their temporal focus and scope.

The real rate of return typically refers to the historical or current actual return of an investment after accounting for observed inflation. It's a backward-looking or present-focused metric that quantifies the true increase in purchasing power from an investment based on realized nominal returns and inflation rates. For instance, if a bond yielded a 5% interest rate last year and inflation was 3%, the real rate of return was 2%.

Adjusted future total return, on the other hand, is a forward-looking projection. It estimates an investment's future total return and then adjusts this projection for anticipated inflation, taxes, and other costs. The "adjusted" component broadens the scope beyond just inflation to include other expected deductions. While real rate of return provides a factual account of past performance in real terms, adjusted future total return offers a comprehensive forecast of what an investor can realistically expect to gain in future purchasing power, based on various assumptions about the future economic environment. The confusion often arises because both aim to provide a "real" picture of returns, but one looks backward at what happened, and the other looks forward at what might happen, with broader adjustments.

FAQs

Why is it important to adjust future total returns?

Adjusting future total returns is crucial because it provides a more accurate picture of how your investment's purchasing power might grow or shrink over time. Without adjustments for inflation and other factors like taxes and fees, a nominal return can be misleading, as rising prices diminish the value of your monetary gains.

What factors are typically included in "adjusted" future total return?

The primary adjustment is usually for anticipated inflation. Other significant adjustments often include expected taxes on investment income and capital gains, as well as ongoing management fees or transaction costs.

Is an adjusted future total return a guarantee?

No, an adjusted future total return is not a guarantee. It is a projection based on various assumptions about future economic conditions, market performance, and tax laws, all of which are subject to change. It serves as an estimate to aid in financial planning.

How does adjusted future total return relate to financial planning?

In financial planning, particularly for long-term goals like retirement, understanding the adjusted future total return is vital. It helps you determine how much you truly need to save and invest to achieve your goals, ensuring that your future accumulated wealth will have the desired purchasing power.