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Real returns! Is inflation eroding your wealth?

The concept of real return is the returns being generated by your investment minus tax and minus inflation. If that is positive then only you are making real returns.

June 23, 2015 8:50 IST | India Infoline News Service
Return is what matters to investors. But in the return chase, one often forgets that the yield on a financial instrument may not necessarily result in return if what you earn is less than the rate of inflation at that point of time.

While risky instruments usually manage to beat the inflation rate regularly, that’s not always the case with the risk-free instrument. Hence, conservative investors should be conscious of this fact and look for inflation-beating returns. Whatever fixed income option one considers, if it does not beat inflation then that means you are actually depleting your wealth, which nobody would like. It is a misconception to look at the absolute returns. Instead, investors should look at the real returns. The concept of real return is the returns being generated by your investment minus tax and minus inflation. If that is positive then only you are making real returns.

Let us take an example, if fixed income option gives you 10 per cent returns and you are in the 30 per cent tax bracket, which means after tax deduction the return would be only 7 per cent and if the rate of inflation is 8 per cent, it would mean you would be losing 1 per cent every year. This is how one should evaluate whatever returns he is getting from an investment in a fixed income asset class.

After deducting tax and adjusting for inflation, an investment must earn at least 2 to 3 per cent per annum. You cannot expect very high return, because you have opted for a fixed income option.

The most popular fixed income option is bank fixed deposits in our country. Apart from that we have all the post office schemes like Kisan Vikas Patra, Senior Citizen’s Saving Scheme and National Saving Certificate. But if the person is in the high tax bracket, he will find that after paying tax he has not beaten inflation. So these schemes are only good for such conservative investors, who are in the low tax brackets or zero tax bracket.

If a bank is giving you 9 per cent interest per annum and inflation is 8 per cent, then you are still earning 1 per cent real return, if you don’t have to pay any tax. But those who pay tax may have to think of high return investment options or different fixed income options like bonds, rated companies deposits/debentures, fixed maturity plans of mutual funds and short term and long term debt funds. These come with different features and need to be studied. As per your time horizon and your objective one should choose the best possible income options.

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