Real rate of return is nominal total return on an investment which is adjusted for changes in prices because of inflation or other external factors. Adjusting the total return to inflation allows you to determinate how much of the return is real return that has kept its purchasing power. For example, let’s say you put $1000 in a bank account and the bank promises you return of 5% per year. The 5% per year that the bank is offering is what we call the nominal rate of return. Is this the actual real return you are getting over a period of time? Well not really. Your real rate of return will depend on the inflation rate for that year. If in the above example at the end of the year the bank pays you 5% on our $1000 but at the same time the inflation rate is at 2%, your nominal return will we 5% but your real rate of return will be an actual 3%. We will see how to calculate the real rate of return with the formula presented below.
The rate of inflation is calculated based on the changes in price indices that are based on price on a group of goods and services. One of the most commonly used price indices is the consumer price index(CPI). It is usually calculated and reported by the Bureau of Economic Analysis and Statistics of a country on a monthly and annual basis. Although the consumer price index is widely used, it is not perfect. A company or investor may want to consider using another price index or even their own group of goods and services prices that are more relevant to their business and industry when calculating the real rate of return.
The formula for calculating the real rate of return is: one plus nominal rate divided by one plus inflation rate minus one. The inflation rate can be taken from consumer price index or GDP deflator.
Real Rate of return =((1+Nominal rate)/(1+ Inflation rate)) -1
So for the example given in the previous section, we calculate the real rate of return like this:
The 3% is the actual real return the you got in real purchasing power after one year of holding your money in the bank account. This is the effective return on an investment after adjusting for inflation.
A more simple way to calculate the real rate of return is:
Real Return = Nominal Return - Inflation
Knowing the real rate of return on your stock investment is crucial before investing your money. Inflation can widely distort your investment returns and reduce the actual value of your investment. Expressing your rates of return in real values instead of nominal values, especially during periods of high inflation, offers a more realistic picture of an investment's value. Although real rate of return is better than nominal when we try to estimate actual returns it is important to know that it is not a perfect measure as it doesn’t account for other lists, such as taxes and opportunity cost. Also the way inflation is measured is not a guaranty that is will reflect the real picture especially when trying to project what the inflation rate will be in the future.