Chapter Six
“Things Are Not Always As They Seem”
Part One: Rate of Return
(Money has no known value until you use it.)
The term “rate of return” is meaningless until all of the costs that are sustained in reaching a certain sum of money are identified and calculated. Until then, the true profit or loss cannot be known which can cause bad financial decisions.
The cost of “converting” money from inside some type of plan or investment to money that is “in hand” to be spent is often very significant. Those costs must be included in the calculation. When a rate of return is stated on any financial product, it is vital to know what is meant: Internal, External, or Inherited.
Example:
An investment grows from $10,000 to $11,000 in one year. The “internal” rate of return at this amount of growth is 10%. The “external” rate of return is the net value after deducting costs.
Costs: |
|
| Invested amount: |
$10,000.00 |
| Income tax on $1,000 gain (@ 28%): |
$ 280.00 |
| Management Fee (@ .9% of $10,000): |
$ 90.00 |
| Lost Opportunity Cost (lost growth, at 10%, on the $370 of costs): |
$ 37.00 |
Inflation (@ 3% of $11,000): |
$ 330.00 |
Total Costs to Achieve $11,000: |
$10,737.00 |
Net Gain in Dollars: |
$ 263.00 |
|
|
External Rate of Return: |
2.63% |
(The “internal” gain is $1,000; the “external” gain is $263; clearly a huge difference. Depending on the investment or other factors, other costs may also exist.)
Internal (“gross”) rate of return: The percentage of change, over a specific period of time, from the original dollar value of an asset to its present value. (Before costs are applied.)
External (“net”) rate of return: The internal (gross) rate of return LESS all costs, direct and indirect, that were incurred in reaching the present value; measuring the profit or loss at the point where you can actually spend the money.
Inherited rate of return: This is the same calculation, but measured at the point where your spouse or heirs can actually spend the money.
The costs of accumulating money include:
Direct Costs: Income tax; capital gains tax; estate (inheritance tax); penalties; and, fees.
Indirect Costs: Inflation; macroeconomic costs (i.e. interest paid on loans, term life insurance premiums, etc.); opportunity costs; and, loss of use costs (loss of velocity).
Opportunity Cost and Velocity of Money are powerful economic principles affecting you right now… without your consent, knowledge, or control. They are explained and illustrated in Chapter 7.
To see how “average rate of return” is also very misleading, please click “Next”.
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