Real Return

Real return is the return on an investment after adjusting for inflation, reflecting the true increase in purchasing power.

Understanding Real Return

Real return provides investors with a clearer picture of how much their investments are actually growing after considering the erosion of purchasing power due to inflation. This metric is crucial for evaluating the effectiveness of an investment strategy over time.

Importance of Real Return

• Purchasing Power: Helps determine the actual increase in wealth since nominal returns can be misleading if inflation is not accounted for.
• Investment Decisions: Aids investors in making informed decisions about where to allocate their capital based on the true performance of their investments.
• Long-term Planning: Provides a better basis for financial planning and retirement savings by incorporating the long-term effects of inflation.

Calculation of Real Return

Real return can be calculated using the following formula:

Real Return = [(1 + Nominal Return) / (1 + Inflation Rate)] – 1

Components:

• Nominal Return: This is the return on an investment before adjusting for inflation. It reflects the percentage increase in the investment value.
• Inflation Rate: This is the rate at which the general level of prices for goods and services is rising, eroding purchasing power.

Real-World Example

Consider an investment with a nominal return of 7% over a year, during which the inflation rate is 3%.

Using the formula:

• Nominal Return = 0.07
• Inflation Rate = 0.03

Real Return calculation:

• Real Return = [(1 + 0.07) / (1 + 0.03)] – 1
• Real Return = [1.07 / 1.03] – 1
• Real Return = 1.0388 – 1
• Real Return ≈ 0.0388 or 3.88%

In this scenario, the real return on the investment is approximately 3.88%, demonstrating the actual growth in purchasing power after considering inflation. Thus, tracking real return is essential for evaluating the performance and sustainability of investments over time.