What is Real Rate of Return?

How much did your investments earn last financial year? I have asked this question to one of my friends who is very happy with the returns generated from her stock portfolio. Her reply is 13%. I have asked one more question – ‘Is this the nominal return or the real rate of return?’. She then asked me to explain the difference between the two. This has given me an idea for a new blog post 🙂

We buy a financial security with an expectation to make some profits. With simple mathematical formula you can calculate the rate of return generated by your investment. But, if you don’t adjust it for INFLATION & TAXES, you are not getting the actual or real rate of return.

Inflation and taxes are very unpopular topics. Both of these drain your investment returns. But, these should be factored in to understand how much you actually gained from your investment.

What is Real Rate of Return?

Let’s first discuss ‘what is inflation?’

In simple terms, it can be defined as either a rise in prices or a fall in the value of money.  It’s an increase in the cost of things that are necessary for humans to live and enjoy life, such as bread, butter, milk, cheese, coffee, oil, shelter, clothing, medical services, chicken, electronics, etc.

One rupee say in 1947 is not the same as one rupee today, both in terms of purchasing power and appearance 🙂

So, when prices rise, the purchasing power of your money decreases.

Below chart gives you an idea about the inflation rate in India during the period from 1959 to 2015.

Let’s now understand the impact of inflation on the returns generated by your investment.

For example, if you make a Rs 1 Lakh worth stock investments that earns 13% in one year, you end the year with Rs 1, 13,000. That means, your money (investment) has grown by Rs 13,000 (we’ll assume no dividends just to keep the illustration simple).

However if inflation is say 6% for the last year, your Rs 1.13 Lakh is only worth about Rs 1,07,000. Inflation devalues not only the interest/income you earned, but the principal amount too. Your real rate of return is only 7% (13% – 6% = 7%. There is a mathematical formula to calculate the exact real rate of return).

Besides the inflation rate the other deduction that you need to consider while calculating the real rate of return is ‘Taxes’. (Kindly note that gains realized on some investments can be tax free. Suggest you to read this article: ‘Tax Treatment of various Financial Investments.’)

Let’s continue with the above example and use the mathematical formulas to calculate the real rate of return.

If you sell your stock investments within 1 year (12 months) of purchase, you have to pay short term capital gain taxes at the rate of 15% on the realized gains.

So, you need to deduct 15% of your gains towards the taxes and then also factor in the inflation rate to arrive at the actual or real rate of return.

The pre-tax returns from your stock investment is 13%. But after paying the taxes, the post-tax returns are just 11.05% only, which is much lower than the presumed return.

Post-tax returns = Pre-Tax returns * { (100-Tax Rate) / 100 }

                               11.05% = 13 { (100 – 15) / 100}

Inflation adjusted & Post Tax returns = { [( 1+ post tax return ) / ( 1+inflation rate )] – 1 } * 100

                           4.76% = { [ (1+.1105) / (1+.06) ] – 1 } * 100

So, the nominal return which is 13%  becomes a meager 4.76% after accounting for taxes and inflation.

To summarize;

• The nominal rate of return is the annual percentage return realized on an investment before being adjusted for inflation and taxes.
• The nominal rate of return gives you an idea of how your money/investment is growing, while the Real Rate of Return tells you how much your purchasing power is growing.

Kindly do not overlook the effects of taxes and inflation when making an investment decision (buy/sell).

Continue reading related article : What is Negative Real Interest Rate? | How Can Interest Rates Be Negative?

(Image courtesy of Stuart Miles at FreeDigitalPhotos.net) 

(Post published date : 13-April-2016)