Your Money: Inflation and your 'real return'

We investors follow the markets closely, but we shouldn't focus solely on the headline stock and bond market returns. What truly determines the soundness of our investments are the "real returns" generated by our portfolios after inflation and taxes.

What's a real return? Investors usually fixate on nominal pretax returns (a.k.a. total returns), but we have to live on the money generated by our "real" returns, which is what we earn and take home after paying capital-gains taxes and accounting for inflation.

Two useful strategies to consider: Research what are known as real return investments that aim to outpace inflation, and move money into Roth retirement savings accounts, which are funded with after-tax money but offer tax-free earnings when we withdraw down the road.

Consider the effect of inflation. In 1983, when inflation was in the double digits, the annualized pretax return on a portfolio that was 60 percent equities and 40 percent bonds was 11.54 percent, according to data compiled by Fidelity. But investors' real after-tax return was actually negative, totaling minus-0.96 percent - a difference of 12.5 percentage points.

More recently, the Federal Reserve has been keeping an eye on the current 2.5 percent inflation rate. Thus, the returns gap for the same 60/40 portfolio has been much smaller, so investors are less concerned.

But inflation has been creeping higher, and historically, the worst times for investors are not just bear markets, but market periods that paired high inflation with rising tax rates. Sound like what we could be facing?

Tax rates and inflation have tended to move more or less together - and with the latest tax act signed by President Obama, we could be headed for such a period.

"Investors need to ask themselves which scenario is more likely: a continuation of the generally low-tax, low-inflation environment we have been in since roughly 1982, or a reversal, with rising tax and inflation rates, as we saw in the 1940s and 1970s," notes Matthew Kenigsberg, senior quantitative analyst in Fidelity's Strategic Advisers.

He writes that a 40/30/30 strategy, which replaces half of the fixed-income portion of a conventional portfolio of 40 percent stock and 60 percent bonds with real-return assets, would in general have held up better during periods of high inflation like the 1940s and 1970s, but fared less well during bond bull markets like those of the 1980s and 1990s.

Check with your broker or adviser to investigate so-called real return mutual funds. PIMCO has a popular one called PIMCO Real Return Fund (PRTNX), as does Fidelity Strategic Real Return (FSRRX), which holds roughly 30 percent of assets in TIPS (Treasury Inflation-Protected Securities), 25 percent in floating-rate securities, 25 percent in commodities and 20 percent in real estate.

Housing prices have started to rise, and in some parts of the country they appear to be rising far faster than the rate of inflation. There are also asset classes that have historically outpaced inflation, such as commodities and precious metals.

The IndexIQ Real Return ETF (CPI) is designed to provide a hedge against the U.S. inflation rate by providing a "real return" or a return above the rate of inflation, as represented by the Consumer Price Index.

A few words on TIPS. A TIPS bond functions like any other Treasury, and with the U.S. government backing the bond, it may be considered lower risk. But unlike a normal Treasury, the principal is adjusted for inflation, so if inflation drives up the value of the bond, the interest payment and principal due at maturity will increase.

In the short term, TIPS may not outperform Treasuries of the same maturity, given the uncertainty surrounding U.S. budget negotiations, notes Roosevelt Bowman, senior fixed-income analyst at U.S. Bank Wealth Management. So TIPS may start off paying less than a comparable Treasury bond, but if inflation takes off, they may pay more in the long run.