How Inflation Eats Trading Returns, With the Arithmetic

Say your account starts the year at 50,000 and ends it at 54,000. That’s an 8% return. If prices in the economy rose 3% over the same year (both numbers 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 away from the exact answer as they rise, so for anything you record, compare across years or use to judge whether your trading is working, use the exact formula. Interest rates split the same way, as real interest rates explained shows.

Tax falls on the nominal gain

Tax on a gain is worked out in dollars. Nobody adjusts the gain for inflation first. So part of what you pay tax on is the inflation itself, which never added a cent of purchasing power.

A 24% tax on the nominal gain turned into a tax of about 38% on the real one. It’s an easy number to miss. The higher inflation runs relative to your return, the wider the gap, 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. In a taxable account you also owe tax on realized gains whether or not you take the money out, which do you owe tax on trades if you never withdraw covers.

Costs and a benchmark

Commissions, spreads, data fees and margin interest all come out in nominal dollars, good year or bad. Measure your result after them. Costs are fixed in dollars while the real gain shrinks as inflation rises, so 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.

Then measure it 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.

Here 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. If you choose one afterward, once you know which comparison flatters you, you’ve defeated the point of having one.

Cash loses purchasing power too

Idle cash earns a real return like anything else, and at zero interest that return is 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. How to choose a high-yield savings account sets out what to look for, and cash waiting for a trade can stay close at hand without sitting at zero.

Trading more won’t get you out of inflation. What you can do is measure for it, and one yearly number, real, after tax and after costs, set against a benchmark, tells you more about your trading than any nominal figure on a statement.