The Real Rate of Return is a measure of the total growth rate an investment achieves, considering the effects of inflation. In other words, it’s the percentage increase in the purchasing power of your investment. Normally, when people refer to the ‘rate of return’, they refer to the nominal rate – that is, the simple growth rate without adjusting for inflation. The Real Rate of Return, on the other hand, gives a more accurate view of the profitability, by subtracting the rate of inflation from the nominal return rate. For instance, if an investment grows by 7% in one year and the inflation rate is 2%, the Real Rate of Return is 5%.
1. What’s the difference between real rate of return and nominal rate of return?
The nominal rate of return is the amount of money generated by an investment before accounting for factors like taxes and inflation. The real rate of return takes these factors into account, offering a more accurate picture of the return once these expenses have been subtracted.
2. Why is real rate of return important?
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The real rate of return is essential as it gives a truthful view of your investment’s profitability by considering inflation. It provides insight into the real purchasing power of your returns over time.
3. How do you calculate the real rate of return?
The formula for the real rate of return is (1 + nominal rate of return) / (1+ inflation rate) – 1. To get the result, you need to subtract 1 and multiply by 100.
4. Is it possible to have a negative real rate of return?
Yes, when the inflation rate is higher than the nominal return, the real rate of return can be negative, indicating a loss in the buying power of your investment.
5. Can I use the real rate of return for all my investments?
Yes, the real rate of return can be used for any type of investment, including stocks, bonds, mutual funds, or real estate, to understand the actual growth or decline in purchasing power.