I talk to a lot of investors and I consume a lot of investing commentary. When investors and investing commentators talk about returns one number is more likely than not to pop out. It has long been conventional wisdom that equity markets will return 10% p.a. to investors over the long run.

Theoretically, with a $100,000 initial investment and $1,000 additional investments every month, in 20 years (with returns reinvested), I would have $1,391,009. Of course, this scenario completely ignores all the realities of investing – the costs of investing and taxation for example. These factors need to be taken into account because what matters is how much money ends up in an investor’s account.

Understanding the holistic return ensures that you have more chance of reaching your financial goals. It also makes it more likely that an investor will pay attention to minimising taxes and fees.

Here are the variables to consider. I’ve focused on Australian equities but this is applicable for any investment.

Brokerage fees

Brokerage differs from broker to broker. CommSec is the most popular broker in Australia, they charge $5 for trades up to $1,000.

This drops our return by $3,592 to $1,387,417 assuming that the only trades are for the additional savings of $1000 every month. Most investors trade far more frequently. We explored overtrading and finding a broker in a recent episode of our podcast Investing Compass.

Management fees

If you’re investing in direct equities, you can skip this part. If your exposure to Australian equities in your portfolio is through an ETF or fund, management fees will detract from your total return. Morningstar manager research analysts’ choice for Australian equity exposure is VanEck Australian Equal Weight ETF (ASX:MVW), awarded a silver medal. I’ve written about their rationale in this article.

The investment management fee for MVW is 0.35%.

Over twenty years, your total return takes a substantial hit. The effect of fees is $76,473, dropping the balance of your portfolio down to $1,310,945.

Buy/Sell spread

This cost is also incurred if your exposure to Australian equities is through an ETF or an individual share. If we use the example of MVW, the transaction costs are estimated to be 0.01%. This again assumes that the only trades are the $1000 in monthly contributions. Most investors trade far more frequently.

This is an additional cost over 20 years of $131. This brings the portfolio to $1,310,814.

Tax on income

This article has generalised the circumstances of this investment to demonstrate how the headline return is not what you will receive. Of course, your circumstances will be different to this example which will result in a different outcome. This is because investing is deeply personal and based on your circumstances. This includes tax.

In the 20 years that you have held this investment, it is likely that your tax bracket has changed. The situation would also be different if you had held this investment in a different tax environment, such as a trust.

For this scenario, we are going to assume the marginal tax rate is 32.5% plus the 2% Medicare levy. This will be applied to a dividend yield of 4.17% which is the average yield of the ASX according to S&P Dow Jones.

Income tax paid over the course of the investment would be $180,443. This of course is not paid from your investment, but it is paid separately when filing your tax. This is an issue that has caught many new investors off guard. In the case of this scenario the taxes paid will be subtracted from the value of the portfolio.

Franking credits

Franking credits are tax rebates that are given to Australian investors who own Australian companies. The rebate is to remove the double taxation of dividends by providing a credit for tax already paid by the company. Franking credits prove to be a consequential contributor to returns.

The ATO provides the monthly average franking rebate yield on the S&P Dow Jones All Ordinaries Index. Between 2018 and 2022 the monthly average is 1.25%. This will vary for specific investors depending upon the individual shares in a portfolio but is useful to look at the overall index. Over the course of 20 years this will boost returns by 1.25% a year or $149,352. Since this credit occurs outside of an investment account, I’ve assumed that it is not reinvested and have simply added the benefit from each year over a 20-year period.

The impact of inflation

Milton Friedman famously said that inflation is taxation without legislation. Inflation is the silent thief of returns. Inflation is a real cost to investors since the whole point of investing is to grow a portfolio to pay for things in the future. As investors we are interested in real returns which means when inflation is taken into account. One underappreciated fact is that inflation compounds. Which means that the impact of inflation on a portfolio is higher than the underlying inflation rate per year.

The impact over 20 years is almost halving your ‘growth’. A portfolio of $1,387,417 in 2043 will have the value of $768,179 in today’s dollars (assuming a 3% p.a. inflation rate).

Capital gains tax

Capital gains tax (“CGT”) occurs upon the sale of an asset that has appreciated in value. For direct assets, this will be when you decide to sell your asset. For investors that are invested through funds, ETFs and other collective investment vehicles, CGT isn’t as clear.

For collective investment vehicles such as managed funds and ETFs there will be changes to the holdings over time. For passive investments, this might be to ensure that the fund is still tracking the index and the same holdings. For example, if we’re looking at the ASX/200, and the 200th stock changes due to a change in market capitalisation. The fund must buy the new stock and sell the share that is no longer in the index. This would mean that the investors in the fund may have CGT distributed to them if the share that is sold has appreciated in value.

For active investments it would be a similar impact if the manager decides to make a change in the portfolio or if the assets have fallen out of the mandated ranges for the fund. For example, Australian equities may make up 50% of a fund. The Aussie market performs extremely well and now makes up 70% of the fund. The exposure must be reduced and the appreciated assets must be sold. This is also the same with equal weighted funds like MVW that must rebalance to ensure that the assets are kept equal weighted.

If these were direct assets, the CGT obligation would be relatively straightforward. In the scenario in this article, I have contributed $100,000 and $1,000 of additional investments every month for 20 years. This means my capital base is $340,000. With my investment appreciating to $1,387,417, my capital gain would be $1,047,417.

We’ve held the investment for more than 12 months, so we receive a 50% discount. Assuming the same 32.5% marginal tax rate, the tax obligation would be $170,205. However some of the gains came from dividends and the tax was already paid. We used a dividend yield of a little more than 4% so I will assume we only owe 60% of the taxes for the capital gains as 60% of the returns came from the overall shares appreciating. That means a total tax of $102,123.

The most obvious way to mitigate the impact of CGT is to hold the assets in a more favourable tax environment – superannuation. Superannuation has a CGT rate of 15% in accumulation phase. It is 0% in retirement. Graham Hand covers minimising taxes in a recent article

The impact of poor behaviour

Behavioural risks reflect our tendency as humans to act emotionally during volatility. We are driven by fear and greed, which is a formula for buying at the top of the market and selling at the bottom. Both individual and professional investors create elaborate models and theories designed to dictate when and why to buy or sell a security. Despite these models there is still a high probability that investors will panic when the market is going down and fear missing out on profits when it keeps climbing.

These actions have been shown to be to the detriment of the returns an investor achieves. This is called the ‘behaviour gap’—the gap between an investment return and the return an investor gets in the same time period. Constantly switching between investments and assets due to emotional responses has been proven to reduce returns for the majority of investors.

It is difficult to say when or if you would switch out of your investments. The study has shown that the average investors earned 1.7% less than the total returns that their fund investments generated over the same period.

This gap between the returns investors actually experience and reported total returns can be attributed to a few reasons – cash flow timing, costs and tax efficiency.

For the average investor this means that poor behaviour reduces the balance by $290,101. And remember this poor behaviour would result in higher transaction costs and more taxes.

My colleague Mark LaMonica explored this issue in a recent article.

The final outcome

There are many variables here that can alter the outcomes that you receive. In this case the total nominal return of 10% which does not include the impact of inflation was reduced to 2.90% on a real or inflation adjusted basis. If we look at the dollar amount we see a reduction from a $1,391,009 portfolio to $819,426 which doesn’t include the reduction of purchasing power for the portfolio.

The purpose of this exercise was to understand the different components of a total return. Specifically, the elements that detract from the returns we often read about and what shows up in our brokerage accounts. We can clearly see that a 10% headline return is not the real return that investors will receive. This is particularly important to factor in when you are understanding how much you need to achieve your goals. Taking the headline rate of return required to achieve you goal could result in a shortfall.

This should also be a wake-up call for investors. Minimising fees, taxes and transaction costs all make a difference. Limiting poor behaviour and resisting the urge to churn a portfolio by constantly chasing the latest fads will make a difference. Headline returns are useful. The return that is actually achieved is what matters.