No. of Recommendations: 4
Calculating a Capital Preservation Threshold Number

Serious investors will be familiar with the Accounting Equation, recognizing its simplicity and power, knowing when and how to use it appropriately and effectively. The following equation (my own derivation) offers the same potential utility.

CPT = (FAMC + TRY) / PAIR

Definitions:
CPT: capital preservation threshold, or the rate of investment return necessary to preserve one's purchasing power.

FAMC: one's fixed asset management costs (ISP, data feeds, hardware, software, books, magazines, research costs, etc.)

TRY: one's “take-home” investment yield after paying Fed and State taxes at ordinary income rates.

PAIR: one's projected, annualized, personally-experienced inflation rate.

Explanations:
FAMC will be a function of one's individual circumstances. A small, passively-managed, $250,000 portfolio might have fixed annual costs as low as $650 , or 0.25%. Active, home-based traders would have costs in the 1-2% range, due to data-feed costs and the need for better equipment and more of it.

TR will also be a personal number. 28% as the Fed rate and 5-9% for the State will be common, where 1- (Fed + State) = TR

PAIR will also be a personalized number, but the following data (the official CPI numbers for the listed time frames) are suggestive:
Years CPI
1951-2001 3.92%
1961-2001 4.45%
1971-2001 5.05%
1981-2001 3.40%
1991-2001 2.60%


A worked example:

CPT = ( 0.25% + 3.92%) / 0.70
= ( 0.0025 + 0.0392) /0.70
= (0.0417) /0.70
= 0.05957

Conclusion: a post-commissions , pre-taxes, pre-fixed-expenses return of ~6.0% is necessary if the investment is to contribute positively to the preservation of purchasing power. If those are one's input numbers, then a 5-year 5.5% CD is a foolish investment, because it fails to achieve the most basic goal of Foolish investing, which is the preservation of purchasing power. Obviously, numbers can be tweaked to generate any result desired, but pie-eyed estimates of inflation, such as Ibbottson's widely used 3.25% are likely to create serious shortfalls over the long haul.

Charlie

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