Calculating the Real Rate of Return
Investors always wish to get the best returns on their investment and compare the various investment options available to them, on the basis of the interest which is offered by the bank or other company. The bank or other financial organization will always declare the nominal rate of return for the investment, However, the prices of various items are also changing over a period of time due to inflation, so investors should consider the net return on their investment while choosing between various investment options available.
The Real Rate of Return (real returns) is defined as the return on a specific investment, calculated in the form of an annual percentage, after adjusting it for changes in the prices of various items due to inflation and other factors. This method helps to find the real return on the investment, how much the investor can purchase after considering the increase in prices after choosing to invest for a specific period instead of spending the money earlier. There is always a risk involved for each investment option, and the investor should consider the real returns before investing in a specific option.
Formula – How to calculate the approximate real rate of interest?
Real returns = (1 + nominal rate/1+inflation rate) – 1
The nominal rate is the rate that is declared by the bank or company accepting investments.It is also called the normal rate or stated rate for the investment. The inflation rate is calculated using the change in the price indices in the country for a specific time period. The price indices are based on the prices of specified goods over a period of time. The consumer price index abbreviated as CPI is one of the most widely used price indices for calculating the inflation rate. Though CPI is popular, investors or companies may consider other price indices. In some cases, they may use a set of goods that are more relevant to the business while calculating the real returns.
Average real return calculator
The real returns are relevant to an investor who postpones his purchases, investing his money instead, hoping to have more money after one year or longer to make the purchases. Though he will earn interest for the period for which he has invested his money, he will also find that the prices of the goods he wished to purchase have also increased. Thus like taxes, inflation can also reduce the value of the investment. Most banks and other companies will only specify the nominal rates, they do not consider inflation. However usually the inflation rate is positive, and this reduces the real returns for the investor.
Though the banks are only advertising the nominal rates, investors who wish to use their money for purchases should consider real rates. However, even the real rate is not very accurate, since it does not consider the other costs of making the investment like opportunity costs and taxes on the income. It is also possible that the inflation rate is not calculated accurately by the organization providing the data. In most cases, the inflation rate is calculated at the end of a specific period, it is usually not possible to predict the inflation in the future.