Adjusted growth return

What Is Adjusted Growth Return?

Adjusted growth return refers to the actual increase in the value of an investment or asset after accounting for various factors that can erode its purchasing power or alter its true profitability. While a nominal return simply shows the percentage increase in an investment's value, the adjusted growth return provides a more realistic measure by considering elements such as inflation rate, taxes, and risk-adjusted return. This metric is crucial within the broader field of investment performance, offering investors a clearer picture of their wealth's true growth and their overall purchasing power.

History and Origin

The concept of adjusting investment returns for factors like inflation gained prominence, particularly during periods of high price increases. Economists and investors realized that a seemingly high nominal return could, in reality, represent a loss in actual buying power if inflation outpaced the investment's growth. The emphasis on distinguishing between nominal and real returns became particularly acute in the late 1970s and early 1980s, when double-digit inflation rates significantly eroded the value of unadjusted investment gains. For instance, while the S&P 500 has historically demonstrated an ability to outpace inflation over the long term, investors must still consider the inflation-adjusted returns to understand the true impact on their wealth.⁴

Key Takeaways

• Adjusted growth return provides a more accurate measure of an investment's performance by considering factors like inflation, taxes, and risk.
• It helps investors understand the real increase in their purchasing power over time.
• The most common adjustment is for inflation, resulting in the real rate of return.
• Other adjustments can include the impact of taxes on investment gains or the inherent risk taken to achieve a return.
• Understanding adjusted growth return is essential for effective financial planning and comparing different investment opportunities.

Formula and Calculation

The most common form of adjusted growth return is the inflation-adjusted return, also known as the real rate of return. This is calculated using the following formula:

Where:

• Nominal Rate of Return is the stated growth rate of an investment before any adjustments.
• Inflation Rate is the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. This is often measured by indices such as the Consumer Price Index (CPI).

For example, if an investment yields a 10% nominal return and the interest rate of inflation is 3%, the calculation for the inflation-adjusted growth return would be:

This indicates that the investment's real growth, after accounting for inflation, is approximately 6.80%.

Interpreting the Adjusted Growth Return

Interpreting the adjusted growth return is critical for understanding the true financial outcome of an investment. A positive adjusted growth return means your investment has increased in value faster than the rate of inflation, thereby increasing your real wealth and purchasing power. Conversely, a negative adjusted growth return indicates that your investment's gains did not keep pace with inflation, leading to a decrease in your actual buying capacity, despite a potentially positive nominal return.

For example, if a savings account offers a 2% nominal annual interest rate but the inflation rate for the year is 3%, your adjusted growth return is negative (-0.97%). This means your money can buy less at the end of the year than it could at the beginning, even though the numerical balance in your account increased. Evaluating the real rate of return allows investors to make informed decisions about whether an investment is genuinely growing their wealth or simply losing less value than other assets.

Hypothetical Example

Consider an investor, Sarah, who purchased shares in a technology company for $10,000 at the beginning of the year. Over the year, the stock appreciated to $11,200, and she received $300 in dividends. Her total nominal return before any adjustments would be ($11,200 - $10,000 + $300) / $10,000 = 15%.

Now, let's assume the inflation rate for the year was 4%. To calculate her inflation-adjusted growth return, we first consider her total nominal return (which includes both capital gains and dividends) as 15% or 0.15.

Using the formula:

Sarah's adjusted growth return is approximately 10.58%. This means that after accounting for the rise in general prices, her investment still yielded a substantial increase in her purchasing power.

Practical Applications

The concept of adjusted growth return is integral to various aspects of finance and investing:

• Retirement Planning: When planning for retirement, individuals must consider how inflation will affect the future purchasing power of their savings. An inflation-adjusted outlook ensures that projected retirement income will genuinely cover future expenses.
• Investment Comparison: Investors use adjusted growth return to compare the true performance of different assets or portfolios. A bond yielding 5% and a stock yielding 8% might seem straightforward, but if the bond's return is tax-exempt and the stock's is heavily taxed, the after-tax adjusted growth return could paint a very different picture. Understanding the tax implications of various investment types is crucial for maximizing after-tax returns.³ The Internal Revenue Service (IRS) provides detailed information on how different types of investment income, such as capital gains and losses, are taxed.²
• Evaluating Fund Managers: For professional investors and fund managers, performance is not solely judged by nominal gains but by how well they perform after accounting for market risk, taxes, and inflation. This leads to the use of metrics that provide a more holistic view of investment performance.
• Government Policy: Economic policymakers consider adjusted growth rates when assessing the health of an economy or the effectiveness of fiscal and monetary policies. Changes in the Consumer Price Index (CPI), as reported by the U.S. Bureau of Labor Statistics (BLS), are a key indicator used to gauge inflation and its impact on real economic growth.

Limitations and Criticisms

While providing a more accurate view of investment performance, adjusted growth return has certain limitations. One challenge is accurately predicting or measuring the rate of inflation rate over long periods. Future inflation is an estimate, and actual inflation can deviate, affecting the precision of long-term adjusted growth return projections.

Another criticism arises when considering adjustments for taxes. Tax rates can vary significantly based on an investor's income bracket, the type of investment, and changes in tax laws, making a universal "after-tax" adjusted growth return difficult to apply across all individuals. Moreover, the impact of taxes can be mitigated through strategies like utilizing tax-advantaged accounts such as IRAs or 401(k)s.

When considering adjustments for risk, various methodologies exist (e.g., Sharpe Ratio, Sortino Ratio), each with its own assumptions and applicability. Selecting the most appropriate risk-adjusted return metric can be complex, and different metrics may yield different interpretations of a portfolio's performance relative to its risk. Many investment strategies are often designed to deliver optimal pre-tax returns, even though after-tax returns are what genuinely matter to investors.¹

Adjusted Growth Return vs. Nominal Return

The distinction between adjusted growth return and nominal return is fundamental in finance.

Nominal return represents the raw percentage gain or loss, while adjusted growth return provides a more insightful measure by incorporating external economic factors. An investment might show a positive nominal return, but if inflation is higher than that return, the investor's purchasing power has actually declined. Therefore, focusing solely on nominal returns can be misleading, especially over longer time horizons where inflation's corrosive effects become more pronounced.

FAQs

What does "adjusted" mean in adjusted growth return?

"Adjusted" means that the raw, stated return of an investment (its nominal return) has been modified to account for other factors that affect the true value or purchasing power of that return. The most common adjustments are for inflation and taxes, and sometimes for the level of risk taken.

Why is adjusted growth return important for investors?

Adjusted growth return is important because it tells investors how much their money has truly grown in terms of buying power. Without these adjustments, especially for inflation rate, an investor might mistakenly believe they are getting wealthier when, in reality, their investment gains are being eroded by rising prices. It helps make more accurate comparisons between different investment options.

Is adjusted growth return the same as real rate of return?

The terms are often used interchangeably, particularly when the adjustment is specifically for inflation. The real rate of return is a specific type of adjusted growth return that accounts for inflation. However, "adjusted growth return" can be a broader term that also includes adjustments for taxes or risk.

How does inflation impact adjusted growth return?

Inflation reduces the purchasing power of money over time. When calculating adjusted growth return, inflation is subtracted from the nominal return. If your investment's nominal growth rate is lower than the inflation rate, your adjusted growth return will be negative, meaning your money can buy less than before.

Does portfolio diversification affect adjusted growth return?

Diversification aims to reduce portfolio risk without sacrificing returns, which can indirectly influence adjusted growth return, especially when considering risk-adjusted measures. By managing risk effectively, a diversified portfolio may achieve more consistent returns that are less volatile, potentially leading to a more favorable and stable adjusted growth return over time. The principles of portfolio theory highlight the importance of balancing risk and return.