Picture a scenario where you are investing in a debt fund on 1st January for a predetermined period of one year. On 31st December, you earn your principal investment back, along with an interest return of 5%. Sounds good, doesn’t it? Keeping that same amount in a savings account would have given you a return of 4%, the debt fund has given you a benefit of 1%.
But is your actual return 5%? The unfortunate answer-no. Why is that? Because of a concept called real returns.
What are real returns?
Consider an investment of 1 lakh at the beginning of the year. Over the period of 12 months, your investment has increased in value to Rs 1.1 lakh. That gives you a return of 10%. But keep in mind that over a year, inflation took place at 4%. Since the amount you have received as a return has reduced in value, taking inflation into consideration. This means that your actual return is not 10%, but rather 6%. This is referred to as your real return. Real Return is also otherwise called an inflation-adjusted return.
If your investment is also subject to any additional tax payment, the return will be adjusted for tax, and the net return is what will be considered as your real return.
Why does real return matter?
Take, for example, an investment that gives you an annual return of 4%. But inflation over that year was 4.5%. Hence, even if you earned more on your initial investment, you still faced a loss since now the value of your investment has fallen.
When you invest in something for a longer period of time, be it equity, debt, or a hybrid investment, the Time Value of Money plays an important role. Had you not made the investment, you would have been able to afford goods/services at a lower rate. But taking inflation into consideration, your Purchasing Power has reduced. Hence, for effective financial planning, it is vital to consider the real rate of return you are receiving.
Inflation will lead to the depreciation of your money, thus reducing your purchasing power per rupee. In a nominal sense, the value of your money remains constant. But considering a real sense of the concept, every time inflation takes place; your money loses value gradually.
How do Real Returns impact your portfolio?
Real Returns are an accurate representation of how your financial position has changed over the duration of the investment. A negative real return states that even if your nominal return is positive, your financial position will be worse off than it was at the beginning. A small real return shows that you are only marginally better off.
How can I calculate the real return on my investment?
Real Return is the return on an investment that is adjusted for inflation. Hence, we can calculate it using the following formula:
Real Rate of Return = [ 1+ Nominal Rate / 1+Inflation Rate ] – 1
The Nominal Rate is the rate earned that is not adjusted for inflation. It is not an accurate measure of actual return earned since it does not account for the Time Value of Money.
The Inflation Rate considered for this purpose is generally derived from the Consumer Price Index (CPI). The CPI refers to the price of a basket of goods and the change in their prices from the base year.
Inflation Rate = [ CPI(x+1) – CPIx ] / CPIx
There are innumerous resources available online such as real returns calculators, which can give you an idea of the real return on your portfolio by estimating your nominal rates and inflation rates.
The bottom line is that inflation is a crucial external determinant of your investment portfolio, which often tends to get overlooked. To truly gauge the performance of your investments, it is necessary to consider the real rate of return. Because if you tailor your portfolio to the nominal rate of return without considering inflation, you might actually be losing money rather than making money.