What is Real Rate Of Return?
331 reads · Last updated: December 5, 2024
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.
Definition
The real rate of return refers to the annual percentage of profit earned 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 economic studies on the impact of inflation. Over time, the purchasing power of money decreases due to inflation, necessitating a method to measure the true yield of investments. This concept became widely used in the early 20th century, especially during periods of high inflation.
Categories and Features
The real rate of return can be categorized into pre-tax and post-tax real rates of return. The pre-tax real rate considers only the impact of inflation, while the post-tax real rate further accounts for the impact of taxes. The main feature of the real rate of return is that it provides a more accurate assessment of investment returns, helping investors make more informed decisions in different economic environments.
Case Studies
Case 1: Suppose an investor invested in a stock in 2020 with a nominal return of 10% and the inflation rate that year was 3%. The real rate of return is 7% (10% - 3%). Case 2: Another investor invested in a bond in 2021 with a nominal return of 5%, an inflation rate of 2%, and a tax rate of 20%. The post-tax real rate of return is 2.4% ((5% - 2%) * (1 - 0.2)).
Common Issues
Investors often confuse nominal and real rates of return, overlooking the impact of inflation on investment returns. Additionally, failing to consider taxes and fees can lead to incorrect estimates of the real rate of return. Investors should consider these factors comprehensively to accurately assess investment returns.
