What is Real Rate of Return

1 Aug 2020 Read 743 Views

Last night I woke up to see a huge shadow. I rolled under my bed in fear and closed my eyes tightly. With great courage, I opened my eyes only to realize that it was my silly sister trying to steal my makeup. The rate of return you receive from a particular asset can be deceiving. That is why investors calculate the real rate of return. It is the return that you acquire after providing for inflation and other expenses. 

The Nominal Rate of Return

The nominal rate of return is the rate without making any deductions like inflation, taxes, etc. This is actually the rate you will see at the advertisements or documents. There is a high chance that an investor may easily be consumed by merely looking at the nominal numbers of a return. But calculating the real return is essential to know what your investment actually brings home. In order to do that, you will have to take into account all the external factors. The formulae for calculating the nominal value is as follows, 

Nominal rate of return = (current investment value / original investment price)-1

The Real Rate of Return 

Have you ever felt cheated when you got something while you were expecting something else? Most of the time, we fall for the advertisements we see or the news we hear and put our money into it. But when we realize that it is not what we expected, we feel cheated and simply put the blame on the others. To be honest, the mistake lies with us. We fail to check the product thoroughly. We are carried away by looking at one side of the story. This ultimately blinds our thinking making us unable to look at the other side. As a result, we are entitled to pay the price of our carelessness. 

Being an investor, you might be stranded in a similar situation as well. You might be expecting a certain rate as your returns. But what you actually receive might not be even closer to the amount you picturized, leaving you to feel deceived. But the real problem is that you failed to see beyond the numbers. Hence, as an investor, it becomes crucial to figure out the real rate of return.

Your investment into any product might invite a number of expenses such as taxes, investment fees, etc. Further, the returns generated must also beat inflation. But the rates in which any investment shows on papers do not include all these. So you should take responsibility for working out the true return. Or else there is a high chance that you might ignore the fact behind numbers. 

The real rate can be calculated as follows, 

The real rate of return = Nominal rate – Inflation  (Or) Real estate of return = ( 1+ nominal rate / 1+ inflation rate) -1 

Importance of Real Rate of Return

Now you might be wondering as to why you should be taking the pain of calculating it. Then in that case, quickly check out reasons as to why you should be calculating the real rate of return of your investment, 

  • It helps you in knowing the actual return your investment is generating. Thus, you can see beyond what is visible to the naked eye. This ultimately stops you from building castles in the air. Further, when you know the true picture, you can build your portfolio in accordance with that. 
  • In order to take the correct and accurate portfolio based decisions, you will need to calculate the real rate of return. Let's take an example. Say I invested in a bond that gives me a return of roughly 12%. I did not calculate the real rate. So I assumed that I would be receiving 12% and stopped any further investment. But on maturity, I had to face the hard truth.
  • When you are making a goal-based investment, it is important to calculate the progress made. Or else there is a high chance of you losing your way or missing the goal. Miscalculations can take you longer than the estimated time when it comes to realizing your goals. 
  • You will understand your investments' real purchasing power with the help of this, which otherwise might be passed over. 
  • Better and appropriate portfolio allocation and reallocation requires a good knowledge of the accurate returns generated. 

Look at this simple illustration. Assume that Ravi invested Rs.10,000 in two financial products, which are Fixed deposit and Equity-linked savings scheme. He undertook both the investments for a period of 3 years. Then his actual return will be as follows 

Particulars 

A fixed deposit (tax-free) 

Equity-linked savings scheme 

Period of investment 

3 years 

3 years 

The nominal rate of return per year

7.80% 

11% 

Inflation 

5%

5%

The real rate of return 

2.80%

6% 

As you can see, there is a huge difference between what you see and what you get from the table. If Ravi had to simply build his goals on the base of nominal return, he might have been fooled at the end of the day. He had to see the real picture for better portfolio management. Similarly, if an investor were to base his decisions upon the nominal rate of return, he is sure to be deceived. 

Normally FDs, NSC, PPF render returns, which are enough to meet the rising inflation. Investments like Mutual funds and stocks are a better option if you are looking to grow your investment. Further, it is also important that you calculate the tax, investment fees, durations, taxes charged as per your tax bracket, etc., in order to arrive at the exact rate of return. Also, make sure to receive any tax concessions, if any.

Conclusion 

Have you ever overlooked the returns? Share your thoughts below. Because, as you know, sharing is caring. 

Every investment you make must help you in battling inflation and act as an effective aid in increasing your wealth. Just looking at the numbers won't do any good. So dive in and perform some calculations. Only then will you be able to find out where you stand in terms of achieving your goal. So the next time you are involved in the purchase of something, why not look deeper and understand everything's real meaning? 

About the Author: Varishika Dinesh | 43 Posts

Varishika is on the verge of successfully completing B.Com. Nothing excites her more than reading books and watching movies. Business, finance, economy? You have her attention.

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