20 April 2022
When you consider that the Bank of England has a long term 2% target rate for inflation, you might assume this is a minor threat to your long-term investment returns. Unfortunately, over the last 12 months, we have seen a gradual strengthening of inflation which hit 7% in March 2022. The Bank of England believes inflation will peak at 8% towards the end of 2022. However, a double-digit spike is not out of the question. This has the potential to decimate real investment returns as opposed to nominal investment returns.
Nominal investment returns are calculated by deducting gross purchase costs from net sale proceeds, presented as a percentage. If you received any dividend income over the year, this would be included in the calculation. While the nominal investment return calculation considers trading costs, it does not take into account comparisons to the market, sector, interest rates or inflation. Therefore, it is essential to look at relative, and real investment returns to get a clear picture.
Perhaps the most common measurement is to compare and contrast your return on capital against the performance of the relevant stock market. This will give you an idea of how your trading has performed relative to the general market. For example, if you focus on US technology shares, it makes sense to compare and contrast your performance against thatof the NASDAQ.
The performance of any stock market will consist of very different returns from sector to sector. For example, when the stock market is flying high, people tend to look towards growth stocks and banking stocks, seen as safe and boring, can suffer in comparison - or vice versa. Therefore, it is perhaps more appropriate to compare and contrast your trading performance against sector performance.
This may get a little complicated for those who regularly trade across different sectors. To get an accurate picture, you need to compare and contrast individual trade returns against the relevant sector. It is crucial that you use the appropriate benchmark and timeframe when comparing and contrasting returns.
Many people tend to go for the more basic comparison of interest rates against investment returns. On the one hand, interest rates are seen as a passive type of investment while day trading/regular trading is more aggressive. On the other hand, it could be beneficial to compare and contrast your performance against the return if you had held the funds on deposit.
Ironically, UK base rates have been minimal over the last 14years. Consequently, any positive return from your trading will likely have outperformed in comparison.
Whether you are looking at a short-term, medium-term orlong-term comparison, your investment return compared to inflation gives you the real return. So what is the real return?
If we assume that the annual inflation rate is 5%, this means that the cost of living will increase by 5% over a year. Consequently, to retain your relative spending power, you need to register an increase of 5% on your investment funds. While a 5% return on your investments in troubled markets would appear impressive, it does nothing but retain your relative spending power. Unfortunately, many people forget to look at the relative spending power of their investment funds - in reality, they should be compared against inflation.
For illustrative purposes only, let's assume that inflation in the UK averages 6% in 2022, 5% in 2023 and 4% in 2024. If you had an investment pot of £100,000, you would need to increase this to £115,752 to effectively "standstill". This is the level at which you would retain your relative spending power over the three years; anything below reduces your relative spending power, and anything above increases it.
To give some perspective, according to figures from the tradingeconomics.com website, inflation in the UK averaged 2.53% per annum between 1989 and 2022.
When you dig a little deeper, looking at investmentperformance figures in detail and comparing and contrasting, every percentage point on returns and costs matters. Here at GIS UK Ltd, we appreciate the need to be competitive on charges while maintaining low latency, high-tech trading services. It is a challenging balancing act that we have successfully delivered on since inception.
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