How should I calculate how much my money is _grown_?

Question

I invest in multiple streams - equities, mutual funds, bank deposits etc. Depending on the asset class, my rate of return is different, naturally. Some asset classes generate higher ROI (with higher risk) while others generate lower (with lower risk).

My primary objective of investing is to grow my money; otherwise I would have kept it in my home (assuming my home is safe - kidding).

At some point, I want to calculate how much my money is grown. What I learned from this forum and the internet is that - there are two insects those eat money:

1. Inflation
2. Tax (include any kind of tax and fees may be)

So, if I want to calculate how much my money is grown, I think (I am not sure) I should subtract these two factors from returns.

Example:

My ROI is 10%. Inflation is 5%. Taxes I have to pay when my investment is cashed are 3%.

Money Grown = ROI - (Inflation + Taxes);
Money Grown = 10 - (5 + 3);
Money Grown = 2;

So apart from what ROI I get, my money only grown by 2%.

Is my understanding correct?
Are there any other factors I should consider while calculating actual returns?
Is there any established formula to calculate actual returns?

Answer 1

You are talking about two concepts using different terms. The standard financial terms when talking about inflation are "real" return and "nominal" return. "Nominal" return is just the actual mathematical return, not adjusted for inflation or anything else. "Real" return is your return after adjusting for inflation. Since the things you can do with your money now cost 5% more (but see my note below), your "real" return is the "nominal" return adjusted for inflation.

You also describe pre-tax and after-tax returns. Remember, though, that you are only taxed on the gains in your portfolio (and in some cases you are taxed less if you have held your investments for a long period of time). So the formula for real after-tax return R given a nominal pre-tax return r, inflation rate I and tax rate T is:

R = r*(1-T) - I

Or in your example:

R = 10*(1-0.03) - 5 = 4.7%

Note that inflation is a currency measure, and does not necessarily affect individuals in the same way. Your cost of living may go up more or less than inflation over time and will also change because of your circumstances (i.e. if you move to a bigger house your maintenance costs go up, which has nothing to do with inflation).

I would also echo the comment that you shouldn't worry about inflation too much. It affects you regardless of what you invest in (provided you're always investing in the same currency) and it's out of your control. So comparing investments by nominal return would be the same as comparing them by real return. Taxes can make a difference if you are comparing taxable versus tax-free investments (like municipal bonds).