How Real Rate of Return Reveals True Investment Performance

When you invest, it is necessary to know how different things affect on returns of your investing. One crucial idea that makes it possible for an investor to distinguish between true gains and apparent gains is called the Real Rate of Return. Here we explain what the Real Rate of Return means, give formulae on how to calculate it & explain why it is important when choosing among various investment options.

What is the Real Rate of Return?

The real rate of return is the yearly profit you make on an investment after considering inflation and taxes. Unlike the nominal rate of return, which only shows the percentage increase in your investment's value, the real rate of return tells you how much your money actually grows in terms of buying power. This adjustment is important because it shows the true increase in value after accounting for the impact of rising prices and taxes.

Real Rate of Return Formula

The real return can be estimated as being a better gauge of the return by taking into consideration inflation. Inflation represents the rate at which prices for select goods and services rise over a given period. Calculate real return using the form below.

Example

Imagine you invest ₹50,000 at the beginning of the year into a savings account with a nominal interest rate (stated rate of return) of 7%. For that year, inflation is 4%.

Here's how to find the real rate of return

• Nominal return calculation:

Your investment earns a nominal return of ₹3,500 because 7% x ₹50,000 = ₹3,500.

• Adjusting for inflation:

However, due to inflation, the purchasing power of your money decreases. With 4% inflation, each rupee you hold buys 4% less stuff. So, effectively, a portion of your nominal return is eaten away by inflation.

• Real rate of return calculation:

To calculate the real rate of return, we use the formula:

Real rate of return = (1 + Nominal return) / (1 + Inflation rate) - 1

Real rate of return = (1 + 0.07) / (1 + 0.04) - 1

= 1.07 / 1.04 - 1

= 1.0288 - 1

= 0.0288(approximately 2.88%)

Even though the nominal return was 7%, the real return was only 2.88%. This means that after adjusting for inflation, your investment's purchasing power actually grew by only 2.88%. In other words, you couldn't buy 7% more stuff with your money, but only 2.88% more.

Importance of Real Rate of Return

Understanding the real rate of return is vital for several reasons:

1. Accurate Measurement of Investment Performance: The Real Rate of Return offers a more realistic picture of just how much you are making from your investment when the effects of inflation are considered.
2. Better Financial Planning: You can make sound decisions on the amount you need to invest by factoring in the real rate of return to meet your financial goals.
3. Portfolio Adjustment: Understanding the actual profit on investment lets you align your investment portfolio with your financial goals and risk tolerance.
4. Comparison of Investment Options: On the same scale, it permits one to compare different investment possibilities, considering the actual growth potential after inflation.

Real Rate of Return vs. Nominal Rate of Return

The nominal rate of return is the rate of return on an investment without adjusting for inflation. It represents the gross percentage increase in the investment’s value. The real rate of return, on the other hand, adjusts for inflation, providing a clearer picture of how much your investment grows in terms of purchasing power.

For example, if you invest in a savings account with a nominal interest rate of 3%, and the inflation rate is 2%, the real rate of return is:

3% - 2% = 1%

Thus, while the nominal return suggests a 3% gain, the real return shows that your purchasing power has only increased by 1%.

Why Does the Real Rate of Return Matter?

To gauge whether an investment is truly profitable or not, the real rate of return must be assessed. In situations where inflation rates are considerably high, it might seem as if nominal returns are higher this could be misleading. Despite this, when you consider inflation then the money has lost its true value.

Consider an example from the late 1970s and early 1980s when double-digit inflation rates were common. Even though nominal interest rates on savings accounts were high, the real rate of return was low due to the high inflation rates, which eroded the purchasing power of the returns.

Investors need to consider the real rate of return to ensure that their investments not only grow in nominal terms but also enhance their actual wealth. This consideration is particularly important for long-term financial planning, such as saving for retirement or a child's education.

The real rate of return is a fundamental metric that every investor should understand. By accounting for inflation and taxes, it provides a true measure of an investment's profitability. When planning your investments, always consider the real rate of return to make informed decisions that ensure your investments grow in real terms, not just on paper.

Understanding the difference between nominal and real rates of return, and calculating the real rate of return, can help you navigate the complex landscape of investing and achieve your financial goals more effectively.