Adjusted return

What Is Adjusted Return?

Adjusted return refers to the calculated gain or loss on an investment after accounting for various influencing factors that can diminish its true value or comparability. This crucial concept within Investment Analysis moves beyond the simple nominal gain to provide a more realistic picture of an investment's performance. Common adjustments include subtracting the impact of inflation, investment fees, and taxes, or accounting for risk-adjusted return. By considering these factors, adjusted return offers investors a clearer understanding of their real purchasing power and helps in more accurate performance measurement. The aim of calculating an adjusted return is to standardize performance metrics, enabling a fair comparison of investment outcomes under different conditions.

History and Origin

The concept of evaluating investment performance beyond simple monetary gains has evolved with the increasing sophistication of financial markets and the understanding of factors like inflation and risk. Early investment calculations often focused solely on the capital appreciation and income generated. However, economists and financial professionals recognized that a dollar earned today does not necessarily have the same purchasing power as a dollar earned decades ago, nor does a high return on a volatile asset inherently signify superior performance over a stable one.

The emphasis on adjusting returns for inflation became particularly prominent during periods of high price increases, such as the 1970s and early 1980s, highlighting the erosion of real wealth. Similarly, as the investment management industry grew, the need for standardized and ethical reporting of investment results became critical. The CFA Institute, for instance, developed the Global Investment Performance Standards (GIPS) to ensure fair representation and full disclosure of investment performance, thereby addressing potential misrepresentations and enhancing comparability across firms.⁹ These standards, while voluntary, guide how investment managers calculate and present historical data, implicitly endorsing the need to consider all relevant factors, including costs and the underlying risk profile, that impact an adjusted return.⁷, ⁸

Key Takeaways

• Adjusted return provides a more realistic measure of investment performance by accounting for factors like inflation, fees, and taxes.
• It helps investors understand the true change in their purchasing power over time.
• Risk adjustment allows for comparing investments with different volatility levels on a more equitable basis.
• Accurate calculation of adjusted return is vital for effective financial planning and long-term wealth accumulation.
• Failing to consider adjustments can lead to an overestimation of actual investment gains.

Formula and Calculation

The specific formula for adjusted return varies depending on the factors being considered. Two common adjustments are for inflation and for fees/taxes.

1. Inflation-Adjusted Return (Real Return)

To calculate the real return, which is an inflation-adjusted return, the nominal return is adjusted for the rate of inflation.

Where:

• Nominal Return: The stated return of an investment before any adjustments.
• Inflation Rate: The rate at which the general level of prices for goods and services is rising, often measured by the Consumer Price Index (CPI).⁶

2. Return After Fees and Taxes

To calculate a return after fees and taxes, these expenses are directly subtracted from the gross return. This illustrates how compounding growth is impacted by these ongoing costs.

Where:

• Gross Return: The total return of the investment before any fees or taxes are deducted.
• Investment Fees: Expenses such as management fees, administrative fees, and transaction costs.
• Taxes: Applicable income taxes on dividends, interest, or capital gains.

Interpreting the Adjusted Return

Interpreting adjusted return involves understanding what the final percentage or value truly represents in terms of wealth and purchasing power. A positive adjusted return indicates that an investor's wealth has grown in real terms, meaning they can buy more goods and services than before. Conversely, a negative adjusted return signifies a loss of purchasing power, even if the nominal return was positive.

For example, if an investment yields a 5% nominal return, but inflation is 3%, the inflation-adjusted return is approximately 1.94%. This means the investor's money can buy about 1.94% more than before, rather than the perceived 5% gain. This is critical for evaluating long-term financial goals, as the time value of money is directly affected by inflationary pressures.

When comparing different investment opportunities or managers, the adjusted return provides a standardized metric. An investment with a lower nominal return but also lower fees, taxes, and risk may offer a superior real return and, therefore, a better adjusted return than an investment with a higher nominal return burdened by significant expenses or excessive risk.

Hypothetical Example

Consider an investor, Sarah, who invested $10,000 in a diversified investment portfolio for one year. At the end of the year, her portfolio grew to $10,800, representing a nominal return of 8%.

However, to calculate her adjusted return, several factors must be considered:

• Inflation: During that year, the average inflation rate was 3%.
• Investment Fees: Sarah paid $50 in management fees over the year.
• Taxes: Sarah's investment generated $200 in taxable dividends and $600 in capital gains. Assuming a combined tax rate of 15% on these gains and dividends, her tax liability is ($200 + $600) * 0.15 = $120.

Let's calculate Sarah's adjusted return:

1. Gross Return (before fees and taxes):
   ($10,800 - $10,000) / $10,000 = 0.08 or 8%.

2. Net Return after Fees and Taxes:
   Actual gain = $800 (gross return) - $50 (fees) - $120 (taxes) = $630.
   Net Return = $630 / $10,000 = 0.063 or 6.3%.

3. Inflation-Adjusted Return (Real Return):
   Using the formula for real return based on the net return:

   $$\text{Real Return} = \frac{(1 + 0.063)}{(1 + 0.03)} - 1$$ $$\text{Real Return} = \frac{1.063}{1.03} - 1 \approx 1.0320 - 1 \approx 0.0320$$

   Sarah's adjusted return, accounting for inflation, fees, and taxes, is approximately 3.20%. This is significantly lower than her 8% nominal return, providing a more accurate picture of her actual increase in purchasing power.

Practical Applications

Adjusted return is a cornerstone of sound financial analysis and decision-making, showing up in various real-world scenarios:

• Individual Investor Assessment: For individual investors, understanding their personal adjusted return helps them gauge the true growth of their wealth and the effectiveness of their investment strategies. It allows them to see if their investments are truly outpacing inflation and compensating for all costs.
• Portfolio Management and Performance Review: Professional portfolio management relies heavily on adjusted return to evaluate the success of different strategies or asset allocations. It enables managers to present a fair picture of their performance to clients, considering all relevant factors.
• Comparative Analysis: Investors and analysts use adjusted return to compare the performance of different investment vehicles (e.g., mutual funds, exchange-traded funds, individual stocks) or investment managers. Without adjusting for factors like investment fees and the level of risk taken, such comparisons can be misleading.
• Tax Planning: Understanding how taxes impact investment returns is crucial for tax-efficient investing. The Internal Revenue Service (IRS) provides detailed guidance in Publication 550, "Investment Income and Expenses," on how various forms of investment income are taxed, which directly influences the after-tax adjusted return.⁴, ⁵ Strategies like tax-loss harvesting or utilizing tax-advantaged accounts are aimed at maximizing adjusted returns by minimizing tax liabilities.
• Retirement Planning: When planning for retirement, projected returns must be adjusted for future inflation to ensure that the accumulated savings will provide sufficient purchasing power to meet future living expenses.

Limitations and Criticisms

While providing a more accurate view of investment performance, adjusted return calculations are not without limitations. One primary challenge lies in the selection and accuracy of the adjustment factors themselves. For instance, determining the "correct" inflation rate can be complex, as various indices exist (e.g., CPI, Personal Consumption Expenditures Price Index), and individual inflation experiences can differ from broad averages.², ³

Another limitation stems from the difficulty in precisely quantifying all relevant costs. While explicit investment fees and taxes are relatively straightforward to measure, implicit costs such as bid-ask spreads, market impact costs, or the opportunity cost of capital can be harder to quantify accurately and consistently.¹ Furthermore, the methodology for adjusting for risk can vary widely, with different metrics (e.g., Sharpe Ratio, Sortino Ratio, Treynor Ratio) yielding different risk-adjusted return figures. The choice of risk model or benchmark can significantly influence the perceived adjusted return, leading to potential subjectivity.

Critics also point out that while a calculated adjusted return offers a quantitative measure, it may not fully capture qualitative aspects of an investment, such as the ease of access to funds, the liquidity of the asset, or alignment with an investor's personal values. Moreover, past adjusted returns do not guarantee future performance, and relying solely on historical adjusted return figures without considering current market conditions or changes in an investment's underlying fundamentals can be misleading.

Adjusted Return vs. Nominal Return

The distinction between adjusted return and nominal return is fundamental in investment analysis. Nominal return is the straightforward, unadjusted percentage gain or loss on an investment over a specific period. It reflects the raw growth of money without considering any external factors that might erode its value. For example, if an investment of $1,000 grows to $1,100, the nominal return is 10%. This is the figure typically quoted by financial institutions or seen in headlines.

In contrast, adjusted return takes that nominal figure and modifies it to account for various real-world costs and economic conditions. The most common adjustments are for inflation, investment fees, and taxes. While a 10% nominal return sounds impressive, if inflation was 5%, fees were 1%, and taxes consumed another 2% of the return, the adjusted return would be significantly lower. The nominal return provides a simple measure of monetary growth, but the adjusted return provides a truer picture of the increase or decrease in an investor's actual purchasing power and overall wealth after all relevant factors have been considered. Failing to distinguish between the two can lead investors to believe their wealth is growing faster than it actually is.

FAQs

Q: Why is it important to calculate adjusted return?
A: Calculating adjusted return is crucial because it provides a realistic assessment of your investment's true performance. It shows you how much your purchasing power has increased or decreased after accounting for factors like inflation, fees, and taxes, helping you make more informed financial decisions.

Q: What factors typically reduce an investment's adjusted return?
A: Key factors that reduce an investment's adjusted return include inflation, which erodes purchasing power; investment fees such as management fees, administrative charges, and trading commissions; and taxes on income, dividends, and capital gains.

Q: Can an investment have a positive nominal return but a negative adjusted return?
A: Yes, absolutely. If an investment's nominal return is lower than the combined impact of inflation, fees, and taxes, then the adjusted return will be negative. This means that despite seeing a positive monetary gain, your ability to purchase goods and services has actually decreased. This highlights the importance of looking beyond just investment performance and considering all real-world costs.