What is Inflation-Adjusted Return?

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The inflation-adjusted return is the measure of return that takes into account the time period's inflation rate. The purpose of the inflation-adjusted return metric is to reveal the return on an investment after removing the effects of inflation.Removing the effects of inflation from the return of an investment allows the investor to see the true earning potential of the security without external economic forces. The inflation-adjusted return is also known as the real rate of return or required rate of return adjusted for inflation.

Definition

The inflation-adjusted return rate is a measure of return that takes into account the inflation rate over a period. The purpose of the inflation-adjusted return rate is to show the investment return after eliminating the effects of inflation. By removing the impact of inflation from the return rate, investors can see the true earning potential of a security without being influenced by external economic forces. The inflation-adjusted return rate is also known as the real return rate or inflation-adjusted required return rate.

Origin

The concept of the inflation-adjusted return rate originated from economists' studies on the impact of inflation on investment returns. As inflation rates fluctuated in the mid-20th century, investors began to realize that nominal return rates did not accurately reflect the actual earnings of investments, leading to the introduction and acceptance of the real return rate concept.

Categories and Features

The inflation-adjusted return rate is mainly divided into two categories: nominal return rate and real return rate. The nominal return rate is the return rate without considering inflation factors, while the real return rate is the return rate after deducting the impact of inflation. The real return rate better reflects the true earnings of an investment, especially in high inflation environments, where its importance becomes more pronounced.

Case Studies

Case 1: In the 1970s, the United States experienced a period of high inflation. Suppose an investor achieved a 10% nominal return rate in 1975, but the inflation rate that year was 8%, resulting in a real return rate of only 2%. Case 2: In 2010, an investor in a low inflation environment achieved a 5% nominal return rate, with an inflation rate of 1.5%, resulting in a real return rate of 3.5%. These cases demonstrate the importance of the inflation-adjusted return rate in different economic environments.

Common Issues

Investors often misunderstand the difference between nominal and real return rates, assuming that a high nominal return rate equates to high earnings. Additionally, ignoring the impact of inflation on long-term investments can lead to poor investment decisions. Understanding the inflation-adjusted return rate helps in more accurately assessing the true value of investments.

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A liquidity trap is an adverse economic situation that can occur when consumers and investors hoard cash rather than spending or investing it even when interest rates are low, stymying efforts by economic policymakers to stimulate economic growth.The term was first used by economist John Maynard Keynes, who defined a liquidity trap as a condition that can occur when interest rates fall so low that most people prefer to let cash sit rather than put money into bonds and other debt instruments. The effect, Keynes said, is to leave monetary policymakers powerless to stimulate growth by increasing the money supply or lowering the interest rate further.A liquidity trap may develop when consumers and investors keep their cash in checking and savings accounts because they believe interest rates will soon rise. That would make bond prices fall, and make them a less attractive option.Since Keynes' day, the term has been used more broadly to describe a condition of slow economic growth caused by widespread cash hoarding due to concern about a negative event that may be coming.

Liquidity Trap

A liquidity trap is an adverse economic situation that can occur when consumers and investors hoard cash rather than spending or investing it even when interest rates are low, stymying efforts by economic policymakers to stimulate economic growth.The term was first used by economist John Maynard Keynes, who defined a liquidity trap as a condition that can occur when interest rates fall so low that most people prefer to let cash sit rather than put money into bonds and other debt instruments. The effect, Keynes said, is to leave monetary policymakers powerless to stimulate growth by increasing the money supply or lowering the interest rate further.A liquidity trap may develop when consumers and investors keep their cash in checking and savings accounts because they believe interest rates will soon rise. That would make bond prices fall, and make them a less attractive option.Since Keynes' day, the term has been used more broadly to describe a condition of slow economic growth caused by widespread cash hoarding due to concern about a negative event that may be coming.

Liquidity Crisis

A liquidity crisis is a financial situation characterized by a lack of cash or easily-convertible-to-cash assets on hand across many businesses or financial institutions simultaneously.In a liquidity crisis, liquidity problems at individual institutions lead to an acute increase in demand and decrease in supply of liquidity, and the resulting lack of available liquidity can lead to widespread defaults and even bankruptcies.

Liquidity Crisis

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Liquidity Event

A liquidity event is an acquisition, merger, initial public offering (IPO), or other action that allows founders and early investors in a company to cash out some or all of their ownership shares.A liquidity event is considered an exit strategy for an illiquid investment or equity with little or no market to trade on. Founders of a firm push toward a liquidity event, and investors like venture capital (VC) firms, angel investors, or private equity firms expect one within a reasonable amount of time after initially investing capital.

Liquid Alternatives

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Liquid Alternatives

Liquid alternative investments (or liquid alts) are mutual funds or exchange-traded funds (ETFs) that aim to provide investors with diversification and downside protection through exposure to alternative investment strategies. These products' selling point is that they are liquid, meaning that they can be bought and sold daily, unlike traditional alternatives which offer monthly or quarterly liquidity. They come with lower minimum investments than the typical hedge fund, and investors don't have to pass net-worth or income requirements to invest. Critics argue that the liquidity of so-called liquid alts will not hold up in more trying market conditions; most of the capital invested in liquid alts has entered the market during the post-financial crisis bull market. Critics also contend that the fees for liquid alternatives are too high. For proponents, though, liquid alts are a valuable innovation because they make the strategies employed by hedge funds accessible to retail investors.

Zero-Coupon Convertible

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Zero-Coupon Convertible

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Zero-Investment Portfolio

A zero-investment portfolio is a collection of investments that has a net value of zero when the portfolio is assembled, and therefore requires an investor to take no equity stake in the portfolio. For instance, an investor may short sell $1,000 worth of stocks in one set of companies, and use the proceeds to purchase $1,000 in stock in another set of companies.