Real rate of return
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Real rate of return is a measure of return on an investment that is adjusted for the effects of inflation. It is calculated by taking the nominal rate of return on an investment, subtracting the rate of inflation, and dividing the result by the amount of the investment. In other words, real rate of return is the rate of return that is adjusted for inflation, taking into account the purchasing power of money. It is a measure of the actual gain or loss on an investment, rather than the nominal rate of return.
Example of real rate of return
- The real rate of return on an investment in a savings account could be calculated by subtracting the rate of inflation from the nominal rate of return on the investment. For example, if the nominal rate of return is 1.5% and the rate of inflation is 0.5%, the real rate of return on the investment would be 1%.
- A real rate of return can also be calculated when investing in stocks or bonds. For example, if an investor purchases a stock for $100 and sells it for $110 one year later, the nominal rate of return would be 10%. However, if inflation was 2% during the same period, the real rate of return would be 8%.
- Real rates of return are also important when considering long-term investments such as mutual funds or real estate. For example, if an investor purchases a property for $200,000 and sells it for $220,000 five years later, the nominal rate of return would be 10%. However, if inflation averaged 2% annually during the same period, the real rate of return would be 6%.
Types of real rate of return
Real rate of return can take many forms, including:
- Nominal rate of return: This is the rate of return on an investment before inflation is taken into account. It is calculated by taking the total return on an investment, subtracting the cost of the investment, and dividing the result by the amount of the investment.
- Real rate of return: This is the rate of return on an investment after inflation is taken into account. It is calculated by taking the nominal rate of return on an investment, subtracting the rate of inflation, and dividing the result by the amount of the investment.
- Expected real rate of return: This is the rate of return on an investment that is expected to be achieved over the life of the investment, after inflation is taken into account. It is calculated by taking the expected return on an investment, subtracting the rate of inflation, and dividing the result by the amount of the investment.
- Risk-adjusted real rate of return: This is the rate of return on an investment after inflation and risk are taken into account. It is calculated by taking the expected nominal rate of return on an investment, subtracting the rate of inflation and the risk premium, and dividing the result by the amount of the investment.
- Terminal real rate of return: This is the rate of return on an investment at the end of its life, after inflation is taken into account. It is calculated by taking the return on an investment at the end of its life, subtracting the rate of inflation, and dividing the result by the amount of the investment.
Advantages of real rate of return
Real rate of return has several advantages:
- It provides investors with a more accurate measure of their true return on investment, taking into account the effects of inflation.
- It allows investors to compare the returns of different investments or assets over time, as it eliminates the effects of inflation.
- It helps investors to determine how much of the return on an investment is due to appreciation in its value, rather than changes in the value of money.
- It helps investors to make better decisions about their investments, as it allows them to compare returns adjusted for inflation.
- It can also be used to compare the returns of different investments over different time periods, as it takes into account the effects of inflation.
Limitations of real rate of return
Real rate of return has some limitations that must be taken into account when utilizing it as a measure of investment performance. These limitations include:
- Inflation is an estimate, not a precise figure. Real rate of return calculations rely on an estimate of the rate of inflation, which can be difficult to accurately predict. This can lead to inaccurate calculations of real rate of return, which can be misleading when making investment decisions.
- Real rate of return doesn't take taxes into account. Taxes can significantly reduce the return on an investment, and are not taken into account when calculating real rate of return. This means that the calculated rate of return may be significantly different than the actual return on the investment after taxes.
- Real rate of return ignores the effects of fees and commissions. Fees and commissions can significantly reduce the return on an investment, but are not taken into account when calculating real rate of return. This means that the calculated rate of return may be significantly different than the actual return on the investment after fees and commissions have been paid.
- Real rate of return doesn't capture the time value of money. Real rate of return does not take into account the value of money over time, which is an important factor when making investment decisions. This means that the calculated rate of return may be misleading when making decisions about long-term investments.
Real rate of return is a measure of return on an investment that is adjusted for the effects of inflation. Other approaches related to calculating real rate of return include:
- Time-weighted rate of return – This approach takes into account the impact of additional contributions and withdrawals over the period of time. This can be used to compare the performance of two investments over a period of time.
- Money-weighted rate of return – This approach measures the return of a portfolio based on the cash flows into and out of the portfolio. This is useful for evaluating the performance of a portfolio over time.
- Internal rate of return – This approach calculates the rate of return of an investment by taking into account the cash inflows and outflows from the investment over a period of time.
In summary, real rate of return is a measure of return on an investment that takes into account the effects of inflation. Other approaches related to calculating real rate of return include time-weighted rate of return, money-weighted rate of return, and internal rate of return. All of these approaches help to compare the performance of an investment over a period of time.
Suggested literature
- Jordà, Ò., Knoll, K., Kuvshinov, D., Schularick, M., & Taylor, A. M. (2019). The rate of return on everything, 1870–2015. The Quarterly Journal of Economics, 134(3), 1225-1298.
- Chambers, D., Spaenjers, C., & Steiner, E. (2021). The rate of return on real estate: Long-run micro-level evidence. The Review of Financial Studies, 34(8), 3572-3607.
