What is the Real Rate of Return?

Companies earn in every financial year. But, most investors are oblivious to the real value earned on the investment made. The real rate of return computes those figures, aiding the investor to find out the earnings on the investment post taxes and inflation. Case-in-point, Mr. A earns Rs 50,000 every month and wants to put 25% of his earnings in a fixed deposit by opening a new account in a bank. In return, the bank guarantees 6% interest for parking his investment with them.

You must be thinking that 6% is the real rate of return on the investment. However, many factors affect the interest rate, like inflation and taxes. You can source the inflation rate of the respective country from the CPI index or GDP deflator. To understand the real rate of return in-depth, let’s walk you through the concept with an example.

What is a Real Rate of Return?

The real rate of return is an annual profit gained on an investment after adjusting the inflation rate. The real rate of return is computed as follows:

One plus nominal rate divided by one plus the inflation rate.

The value is subtracted by one to obtain an accurate figure. The formula is:

Real Rate of Return = (1+Nominal Rate) ÷ (1+Inflation Rate) – 1

There are innumerable modes of computing the real return value that you’ll be attaining on your investment but it does not consider inflation as a deciding factor. Through the real rate of return, one can also comprehend the purchasing power of the currency for that period in time. Since inflation diminishes the actual amount of products one could buy, the real rate of return considers this factor to find the buying power.

Additionally, the investor gets to know the exact percentage of nominal return as the real rate of return. Along with the inflation rate, you should also take investment charges, taxes, and other aspects while computing the real rate of return. During the inflation time, you can use the real rate of return to find out how well their investments are doing.

Based on that, you can either shuffle your investments or modify your existing portfolio by consulting a professional financial advisor. Moreover, you can compare your investments with other investments you made, and see how it’s performing. Doing so would give you an idea of whether your investment in a particular financial asset class is laudable or not. This method depicts the success or fiasco of your investment and gauges the accurate amount you would receive at the end of the maturity.

Difference Between Real Rate of Return and Nominal Rate of Return

Since both concepts are connected, spotting their differences would give you clarity on what to look for post-investment.

You can enunciate interest rates in the real rate of return and nominal rate of return. While the former considers the inflation rate for adjusting, the latter doesn’t. Additionally, the real rate of return proclaims unerring figures whereas the nominal rate of return is like the gross value.

Importance of Real Rate of Return

Just like every computing tool has its perks, the real rate of return does too. If you want to invest in any financial avenue, you may want to first check this value. There are innumerable affirmative reasons why an investor needs to compute the real rate of return:

1. It’s not easy to find out the true worth of an investment unless you dig deeper. The real rate of return lifts the trouble with a simple calculation. With this result, you’ll get to know how much your currency’s buying power will be in today’s market.
2. As this reveals the accurate figures for your investment, it’ll be easy for you to plan your short-term or long-term goals.
3. Except at the time of deflation and crisis periods, the nominal rate of return always telecasts exorbitant numbers when compared to the real rate of return.
4. The rate of return value shows the list of risk factors involved in finding the absolute realized number. It also determines the risk-reward of investment, helping you to build a solid portfolio.

Example of Real Rate of Return

For instance, Mr. Anil took a bond that offers a 6% return annually. The inflation rate in the market shows 5% yearly. Now, the real rate of return on the bond is just 1%. Here, though the nominal rate of return on the bond is 5%, Mr. Anil gets the real value of 1%, which is notably low.

Another example, say Mr. Anil wants to buy a nice scooter. The current market price for it is $5000. Instead of proceeding to buy the scooter first, Anil deposited in some scheme and earned $300. Anil created a reserve and added the extra earned money to his investment to take leverage when necessary.

Hence, the earned interest rate is 3% and the returns made after one year are $5300. Woefully, due to inflation, the prices surged by 2 per cent. As the real rate of return considers inflation, the scooter price turns to $5200. The purchasing power of the investor is 1% and also the real rate of return value on your initial investment.