How Inflation Eats Trading Returns, With the Arithmetic

Say your account starts the year at 50,000 and ends it at 54,000. That is an 8% return. If prices in the economy rose 3% over the same year, and both numbers here are hypothetical, the 54,000 buys less than 8% more than the 50,000 did.

You can work out how much less. Taxes widen the gap. Costs widen it again.

Nominal and real

The nominal return is the change in dollars. The real return is the change in what those dollars can buy.

The approximation is close when both rates are low and drifts further from the exact answer as they rise, so for anything you record, compare across years or use to judge whether your trading is working, the exact formula is the one to use. The same split applies to interest rates, as set out in real interest rates explained.

Tax falls on the nominal gain

The tax on a gain is calculated on dollars. Nobody adjusts the gain for inflation first. So part of what you pay tax on is the inflation itself, which was never a gain in purchasing power at all.

A 24% tax on the nominal gain turned into a tax of about 38% on the real one. The higher inflation runs relative to your return, the wider that gap gets, and in a year when the nominal gain is smaller than inflation you can owe tax on a position that lost purchasing power.

Actual rates depend on your income, your holding period and the IRS rules in force, and short-term gains are taxed as ordinary income. Tax is also owed on realized gains in a taxable account whether or not you take the money out, which is covered in do you owe tax on trades if you never withdraw.

Costs and a benchmark

Commissions, spreads, data fees and margin interest all come out in nominal dollars, and they come out whether the year is good or bad. A trader’s result should be measured after them. Because costs are fixed in dollars while the real gain shrinks as inflation rises, a hypothetical 500 of costs that takes one eighth of the 4,000 nominal gain above takes about a fifth of the 2,427.18 real one, and a larger share again once tax is counted.

It should also be measured against something. A simple benchmark is what a broad index fund held all year would have done, with its own real return worked out the same way.

In this example the higher nominal return lost. That outcome depends entirely on the numbers chosen. Run it with your own.

Pick the benchmark before the year starts. Choosing one afterward, once you know which comparison flatters your result, defeats the purpose of having one.

Cash loses purchasing power too

Idle cash has a real return too. At zero interest, it loses whatever inflation takes.

• 10,000 idle, earning 0, with 3% hypothetical inflation: 10,000 / 1.03 = 9,708.74 in start-of-year dollars.
• The same 10,000 earning a hypothetical 2%: 10,200 / 1.03 = 9,902.91.

Check what your broker pays on uninvested cash, if anything, and compare it with what a separate account would pay. Our guide on how to choose a high-yield savings account sets out what to look for, and cash that is waiting for a trade can stay close at hand without sitting at zero.

Inflation cannot be avoided by trading more. Measuring for it is the part you control, and a yearly real, after-tax, after-cost number against a benchmark tells you more about your trading than any nominal figure on a statement.