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 based on the interest 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.
Definition
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 various items’ prices due to inflation and other factors. This method helps find the real return on the investment and 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.
Real rate of return formula
“The real rate of return formula is the sum of one plus the nominal rate divided by the sum of one plus the inflation rate which then is subtracted by one. The formula for the real rate of return can be used to determine the effective return on an investment after adjusting for inflation.”
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 country’s price indices 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 more relevant goods to the business while calculating the real returns.
Average real return calculator
Explanation
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 he has invested his money, he will also find that the prices of the goods he wishes 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 nominal rates; they do not consider inflation. However, usually, the inflation rate is positive, reducing the real returns for the investor.
Limitation
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 investing opportunity costs and taxes on 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 impossible to predict inflation in the future.
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