Many have heard the common adage: “Successful investing is about managing risk, not avoiding it.” One of the risky givens every income earner has is of inflation. Money that remains idle in a bank account without being transformed into an asset loses its purchasing power as inflation increases. Hence, when one earns a profit from their investment, it’s wiser to consider this profit earned by considering how much inflation would impact it. This sets the stage for the metric known as ‘real rate of return.’
What is the real rate of return?
Let’s say you earn a percentage of profit annually on your investments. Now suppose, keeping in mind, the impact on inflation on this profit in the future, you adjust your profit by considering inflation. This adjusted value is your ‘real rate of return’ on your investment. Hence, by its definition, this metric can accurately give you the true purchasing power of any amount of profit earned over time.
By adjusting their nominal rate of return for inflation, an investor can now determine how much of that return will actually give them purchasing power. In other words, they can learn how much of the return is real profit. Inflation is just one factor among many that reduce purchasing power. Investors should also keep in mind other factors such as investing fees, taxes, and more, so they can estimate the real returns before they go for an investment option.
Real Rate of Return Formula
Understanding how to calculate this metric can help you measure the returns on your investments in a better capacity. You can either calculate it yourself or choose among the abundant ‘real rate of return calculators’ available online. It is incredibly simple to estimate their true purchasing power. The real rate of return formula looks as follows:
Real rate of return = Nominal interest rate (%) — Inflation rate (%)
The nominal rate of returns is almost always higher than the real rate of return. There are some key moments in history where one’s nominal rate of return has been lower than their real rate as their economy saw deflation or zero inflation. However, these moments are rare in comparison to those in which investors see inflation chipping away at their earnings.
Real Rate of Return Example
As an example of how to use the real rate of return formula to calculate it on your investments, consider the following. Suppose a bond you are planning to invest in pays investors a 5% interest rate annually. Now by doing a quick search of your country’s inflation rate, you can learn this percentage value. Let’s assume your country’s inflation rate is 3%. Hence, the real rate of return is equal to the difference between 5% and 3% which is 2%. Hence, your purchasing power from that particular bond increases by 2% each year, even though the interest earned is 5%.
As a more specific example, let’s say you had saved by ₹1,00,000 to purchase a new car. Before going through with your purchase, you decided to invest this money in a one-year bond investment giving you 5% interest. This way you can have some money left over after you purchase your car one year later. After all, the 5% rate of return will earn you some profit. The profit will give you ₹1,05,000 at maturity. But with annual inflation of 3% each year, the average car that used to cost ₹1,00,000 would cost ₹1,03,000. Hence, calculating the real rate of return can help you estimate if delaying your car’s purchase by a is worth the ₹2000 you will save.
When you are looking at the interest rate on investment, keep in mind that there are two ways of looking at this number: the nominal interest earned and the real interest earned. The difference between the real rate and the nominal rate is that the former is adjusted for inflation. This is why, most of the time, one’s nominal rate of interest is always higher than the real rate of interest. To know your true purchasing power, you can easily calculate the real rate of return by subtracting the inflation rate of your country from your nominal interest earned on any single investment.