Real Rate Of Return
The real rate of return is the annual percentage of profit earned on an investment, adjusted for inflation. Therefore, the real rate of return accurately indicates the actual purchasing power of a given amount of money over time.Adjusting the nominal return to compensate for inflation allows the investor to determine how much of a nominal return is real return.In addition to adjusting for inflation, investors also must consider the impact of other factors, such as taxes and investing fees, to calculate real returns on their money or to choose among various investing options.
Real Rate of Return
Definition
The real rate of return refers to the annual percentage yield on an investment after adjusting for inflation. It accurately reflects the actual purchasing power of a certain amount of money over time. By adjusting the nominal rate of return to compensate for inflation, investors can determine how much of the nominal return is the real return.
Origin
The concept of the real rate of return originated from studies in economics and finance on the impact of inflation. Over time, economists and investors realized that the nominal rate of return does not accurately reflect the true yield of an investment because inflation erodes the purchasing power of money. Therefore, the method of calculating the real rate of return was proposed to more accurately assess the true yield of investments.
Categories and Characteristics
The real rate of return can be categorized based on different adjustment factors:
- Inflation-adjusted real rate of return: Considers only the impact of inflation.
- After-tax real rate of return: Considers the impact of taxes in addition to inflation.
- Fee-adjusted real rate of return: Considers the impact of investment fees in addition to inflation and taxes.
These categories help investors more comprehensively evaluate the true yield of their investments.
Specific Cases
Case 1: Suppose an investor earns a nominal return of 5% in one year, while the inflation rate during the same period is 2%. The real rate of return can be calculated using the following formula:
Real Rate of Return = Nominal Rate of Return - Inflation Rate = 5% - 2% = 3%
Therefore, the investor's real rate of return is 3%.
Case 2: Suppose an investor earns a nominal return of 8% in one year, the inflation rate is 3%, and the tax rate is 20%. The real rate of return can be calculated using the following formula:
After-tax Nominal Rate of Return = Nominal Rate of Return * (1 - Tax Rate) = 8% * (1 - 0.2) = 6.4%
Real Rate of Return = After-tax Nominal Rate of Return - Inflation Rate = 6.4% - 3% = 3.4%
Therefore, the investor's after-tax real rate of return is 3.4%.
Common Questions
Question 1: Why is the real rate of return more important than the nominal rate of return?
Answer: The real rate of return is more important because it considers the impact of inflation on purchasing power, providing a more accurate reflection of the true yield of an investment.
Question 2: How is the real rate of return calculated?
Answer: The real rate of return can be calculated by subtracting the inflation rate from the nominal rate of return. If taxes and fees need to be considered, further adjustments to the nominal rate of return are required.
