Inflation is the #1 enemy for all investors. Taxes are the
#2 enemy. Combined, inflation and taxes make a mighty opponent that makes it
possible to loose even with positive investment return. To see why, lets
analyze a hypothetical investor “Jack” who wants to buy a new car worth $25k.
Jack has the money and he could buy the car immediately; however, Jack knows
about the time value of money and decides to invest the money in stock market
for 5 years before buying the car.
For the next 5 years, the inflation averages 4% and the
stock market return is 4.5%. The price of the new car has risen to $25k*1.045
= $30.4k. Jack is not worried first: His investment has risen to $31.2k.
Unfortunately, Jack has to pay taxes for his investment gains. After taking out
15% for the long term capital gains, Jack is left with $29.9 which is not
enough for a new car. The moral of the story is that investor should beat both
the inflation AND taxes to come ahead.
Geek notes:
The minimum rate of return r to beat both inflation and
taxes is given by In our example, inflation is 4% and tax is 15% giving CAGR =
4.7%.
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