Factoring in inflation in your FIRE portfolio returns

The S&P 500 is often seen as the benchmark for U.S. stock market performance, comprising 500 of the largest U.S. companies. Historically, the average annual return of the S&P 500, including dividends, has hovered around 10%. This average, however, is spread over decades, covering years of economic boom as well as downturns. People investing in the S&P 500 are often counting on the long-term growth potential, but it’s crucial to understand that returns can fluctuate significantly from year to year and how inflation affects those returns.

In this article we look at historical returns of the SP500, put them into perspective with inflation and also look at potential tax impacts using some US states as example.

Historical Average Returns of the S&P 500

Looking at the data over the last century:

Long-term Average (since 1920s): Around 10-11% annually, with this including both capital appreciation and dividend reinvestments.

Recent 50-year Average: Closer to 9-10%, still a strong return but impacted by market downturns such as the dot-com crash of 2000 and the financial crisis of 2008.

Last 10-20 years: Fluctuating between 7-10%, depending on the period in question and whether large events like the 2008 financial crisis or the COVID-19 pandemic are factored in.

These historical numbers are nominal returns, meaning they don’t account for inflation. This is important, especially for people planning long-term goals like retirement.

FIRE and the Use of VTI as a Tool

The Financial Independence, Retire Early (FIRE) movement has gained popularity in recent years, with individuals aiming to save and invest aggressively to achieve financial independence well before traditional retirement age. A key principle in FIRE is maintaining low costs while maximizing returns. This is where Vanguard’s Total Stock Market ETF (VTI) comes into play.

VTI, which tracks the entire U.S. stock market, is a favorite among the FIRE community because:

1. Low Fees: With an expense ratio of 0.03%, it’s one of the lowest-cost investment vehicles available.
2. Broad Diversification: VTI invests in over 4,000 U.S. companies, providing broad exposure to large, mid, and small-cap stocks, reducing the risk tied to individual companies or sectors.
3. Strong Long-Term Performance: Historically, VTI has delivered returns comparable to the S&P 500, typically around 8-10% annually, making it a suitable vehicle for long-term growth.

Many in the FIRE movement aim to save 50-70% of their income and invest primarily in VTI. With disciplined saving and investing in an asset like VTI, they leverage compound interest over time to reach their target investment number, which is usually calculated as 25 times their annual expenses. This is based on the 4% rule, which suggests that withdrawing 4% of your portfolio annually should allow you to live off the returns indefinitely, assuming historical market averages hold true.

The Importance of Factoring in Inflation

When planning long-term financial goals, especially retirement, it’s crucial to consider inflation. Over time, inflation erodes the purchasing power of money. A return of 10% might sound attractive, but if inflation is running at 3%, your real return—the return adjusted for inflation—is actually closer to 7%. This makes a huge difference in long-term planning.

For example:

• If you invested $100,000 and earned a nominal return of 10% per year, you would have $110,000 at the end of the year.
• However, if inflation is 3%, the purchasing power of that $110,000 is equivalent to only about $106,796 in today’s dollars.

Thus, your real return is 6.7%, not the 10% nominal return. Sadly this might not be the full picture, because official inflation data suggest inflation is at an annual average of 3% but real inflation could be closer to 6%!

As we explore in our article “Bitcoin will never be too expensive to protect your savings against inflation”  famous economist Lyn Alden suggests when accounting for increase of money supply actual annual inflation could be closer to 6% than 3%. Click on the above link to learn more about how this is calculated.

Using CPI Data to Calculate Real Returns

The Consumer Price Index (CPI) is the most commonly used measure of inflation. It tracks the changes in prices for a basket of goods and services over time, providing insight into how much inflation has occurred. To calculate your real return using CPI data, follow these steps:

1. Determine Your Nominal Return: This is the return you actually received from your portfolio before considering inflation.
2. Find the Inflation Rate: Look up the CPI data for the period in question. The Bureau of Labor Statistics (BLS) publishes monthly and annual inflation rates.
3. Apply the Real Return Formula:
   
   For example, if your nominal return is 10% and inflation is 3%, the real return is:
   

By adjusting your portfolio’s nominal return for inflation, you get a clearer picture of how much your wealth is actually growing in terms of purchasing power. Note that the CPI uses official inflation data at an annual average of 3%.

The below chart from Bravos Research show how inflation impact SP500 over time and that also considers an average inflation of 3% and does not factor in potential capital gain taxes.

The Impact of Taxes on Your Returns

Another crucial factor in portfolio returns is taxation. Different types of investments are taxed in various ways, and tax rates can vary depending on where you live and how you invest.

1. Federal Capital Gains Tax: In the U.S., the capital gains tax on investments held for more than a year is typically 15% or 20% for high earners. For those in the FIRE community, minimizing capital gains taxes is important for maximizing their long-term wealth.
2. State Taxes: Each state has its own tax rates. For example:
   • California: Has some of the highest state income taxes, with rates going up to 13.3% on capital gains
   • Texas and Florida: These states do not have a state income tax, meaning investors there only pay federal taxes on their investment returns.
3. Tax-Advantaged Accounts: Many FIRE followers use IRAs and 401(k) accounts to grow their investments tax-free or tax-deferred, allowing them to avoid taxes on investment gains until retirement. Roth IRAs, for example, allow tax-free withdrawals in retirement, assuming you follow the rules.

Conclusion

Investing in the S&P 500 or broad-market ETFs like VTI offers robust long-term growth, but it’s essential to consider factors like inflation and taxes when calculating your real return. Adjusting your portfolio’s nominal returns for inflation using the CPI allows you to better understand how much your wealth is growing in real terms. Moreover, tax considerations—both federal and state in the US —can significantly impact your overall portfolio returns. Understanding these factors and planning accordingly is crucial, particularly for those on the path to financial independence and early retirement.

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