Factoring inflation into investment returns

The WSJ ran this article today on WSJ.com.  I can’t tell if the author is trying to employ scare tactics or is genuinely trying to educate investors.  The thesis of the article is that when you factor in inflation to the returns of the Dow Jones Industrial Average the results are not as attractive.

This seems fairly obvious but it is an important concept in making calculations used in financial planning.  For example, if a person is trying to calculate how much they’ll need to invest each month in order to have enough to retire they not only need to consider how much they’ll money will grow but they also need to factor in the impact of inflation.  This is accomplished by using the “real return” instead of the “nominal return” or “average return” as the expected rate of return for the calculation.

Here’s how real return is calculated:

real return= (((1+r)/(1+i))-1)*100

where r=expected nominal return, i=expected inflation rate

For example, let’s assume the expected return on an investment is 9.00% and expected inflation is 4.0%:

real return=(((1+.09)/(1+.04))-1)*100=4.81%

In this instance the investment is expected to grow at a 4.81% annual rate after adjusting for the impact of inflation.  It’s important that investors use reasonable assumptions because it will have a tremendous impact on the end result.