What is Real Rate of Return - Meaning & Example

Investing your hard-earned money is an intelligent way to secure your future. However, before investing, it is essential to understand the concept of the real rate of return and how it affects your portfolio. Actual returns matter because they help you make informed investment decisions. Knowing about your actual returns help you reach your financial goals. 

This article will discuss the real return rate, how it differs from nominal returns, and why it is essential for your portfolio.

What is the real rate of return?

The real rate of return is the rate of return on an investment after accounting for inflation. Simply put, it is the return you earn on your investment after adjusting it for the inflation rate. For example, if your investment makes a 10% return, but the inflation rate is 5%, your real rate of return is only 5%. The real rate of return is essential because it helps you determine the actual value of your investment.

Nominal return vs. real return

Nominal return and real return are two different concepts. Nominal return is the rate of return on investment without adjusting for inflation. Real return is the rate of return after adjusting for inflation. This is because the nominal return does not consider the purchasing power of money over time, while the real return does.

For instance, suppose you invested $1,000 in a stock that gave you a nominal return of 8% per year. After one year, your investment will be worth $1,080. However, if the inflation rate is 3%, the purchasing power of your investment would only be $1,048.40, which means that your real return is only 4.84%.

Expected return of a portfolio

The expected return of a portfolio is the anticipated rate of return on investment based on past performance and market trends. However, it is important to note that expected returns are not guaranteed. Actual returns can differ from expected returns. 

When creating a portfolio, investors aim to maximise their expected return while minimising the risk. A portfolio with a higher expected return generally comes with higher risk.

Why do real returns matter to your portfolio?

1. Real returns help you reach your financial goals

Your financial goals depend on the actual value of your investments, which is why real returns matter. For example, suppose you want to save for your child's education, which can be anticipated to cost $50,000 in ten years time. 

If you invest in an instrument that earns a nominal return of 10% per year, but the inflation rate is 4% the real return on your investment is only 6% To reach your financial goal of $50,000, you need to invest more money or earn a higher real rate of return.

2. Real returns affect your purchasing power

Inflation erodes the purchasing power of money over time. For example, suppose you invested $10,000 in a bond that earned a nominal return of 5% per year, but the inflation rate was 3% After ten years, your investment would be worth $16,386, but the purchasing power of your investment would only be $12,261. 

This means that your real return is only 2% per year. Therefore, you need to earn a real return higher than the inflation rate to maintain your purchasing power.

3. Real returns help you choose the right investment

Real returns help you compare the returns on different investments accurately. For example, suppose you have two investment options: Option A and Option B. 

Option A gives you a nominal return of 8% per year, while Option B gives you a nominal return of 6% per year. However, the inflation rate is 4%

After adjusting for inflation, the real return on Option A is only 4% while the real return on Option B is only 2% Therefore, option A is a better investment option because it provides a higher real return, even though its nominal return is lower than Option B.

4. Real returns help you manage risk

Real returns help you assess the risk of an investment accurately. For example, suppose you invest in a stock with a nominal return of 15% per year, but the inflation rate is 8% After adjusting for inflation, the real return on your investment is only 7% 

If the stock market crashes and your investment loses value, you might have a negative real return. In contrast, investing in a bond that gives you a nominal return of 8% per year but the inflation rate is only 3% it might provide you with a higher real return in the long run, with lower risk.

5. Real returns help you make informed investment decisions

Real returns help you make informed investment decisions by providing a more accurate picture of the performance of your investments. For example, suppose you invested $10,000 in a mutual fund that gave you a nominal return of 12% per year for five years. After five years, your investment would be worth $18,969. 

However, if the inflation rate were 5% per year, the purchasing power of your investment would only be $13,661. This means that your real return is only 3.56% per year. By considering the real return, you can assess the actual performance of your investment and make informed decisions about future investments.

Conclusion

Real returns matter because they help you make informed investment decisions, reach financial goals, and manage risk. Therefore, it is essential to understand the difference between nominal and real returns and how inflation affects the value of your investments over time. 

By considering the real rate of return, you can choose investments that provide a higher real return and maintain your purchasing power over time. Real returns are essential to consider when creating a portfolio that meets your financial objectives and risk tolerance.

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Disclaimer

The investment options and stocks mentioned here are not recommendations. Please go through your own due diligence and conduct thorough research before investing. Investment in the securities market is subject to market risks. Please read the Risk Disclosure documents carefully before investing. Past performance of instruments/securities does not indicate their future performance. Due to the price fluctuation risk and the market risk, there is no guarantee that your personal investment objectives will be achieved.