How to Calculate the Real Rate of Returns, Inflation-adjusted
The Real Rate of Return | Adjust Investment Returns to Inflation
With financial matters, I like to keep it simple. However, Investments have a few “moving parts” that must be understood in order to compare “apples to apples”. For instance, when we monitor the performance of current investments and future investments, it is necessary to understand these 2 points:
1) the relation between the return on Investments and Inflation and
2) how to calculate inflation-adjusted returns
Returns and Inflation
While inflation is the decline of purchasing power of a given currency over time, the inflation rate is the degree to which the value of a currency is falling, and consequently, the general level of prices for goods and services is rising. From an academic macroeconomic perspective, Inflation can be viewed positively or negatively depending on the individual viewpoint and rate of change. However, from a practical investment point of view, Inflation lowers the size of a positive return and increases the magnitude of a loss; this hidden tax eats away our returns.
It is necessary to monitor Inflation with our investments. Each country or economic area (US, Europe, etc.) tends to have different inflation rates; the same rates change over the years. As such, it is important to know the current inflation rate in the country or the currencies you invest in and calculate the inflation-adjusted return, also known as the real rate of return.
In summary, removing the effects of inflation from the (nominal) return of investment allows the investor to:
a) see the true earning potential of the investment without external economic forces
b) compare true earning potential between investment in different currencies and/or countries (i.e. with different inflation rates)
How to calculate the Real Rate of Return (Inflation adjusted-returns) | The linear approach
The simple approach uses a linear estimation. In this way, there is no need to calculate any compounding or geometric growth of returns and inflation. This approach still provides an indication of the impact of inflation on the investment; it is a quick approach.
(Nominal) Return – Inflation = Real Rate of Return
Example 1. An Investment with 5 % (annual) returns in a market with 3% (annual) inflation. At the end of the year, there is a net return of 2%. (5% – 3% = 2%).
Example 2. An Investment with 2 % (annual) returns in a market with 3% (annual) inflation. At the end of the year, there is a negative net return of -1. (2% – 3 % = -1%).
How to calculate the Real Rate of Return (Inflation adjusted-returns) | The compounding approach
This second approach is different: instead of relying on a linear approach, it takes into account the fact that inflation and returns compound over time. If we focus on how investments are doing over the long-term, this formula presents a better picture.
(1+ Nominal Return) / (1+ Inflation) – 1 = Real Rate of Return
Example 1. An Investment with 5 % (nominal annual) returns in a market with 3% (annual) inflation. At the end of the year, there is a net-return of: 1.9%.
(1+ 5%)/ (1+3%) -1 = (1.05 /1.03) -1 = 0.019 = 1.9%
Example 2. An Investment with 2 % (nominal annual) returns in a market with 3% (annual) inflation. At the end of the year, there is a negative net return of -1.
(1+ 2%)/ (1+ 3%) -1 = (1.02 / 1.03) -1 = – 0.009 = -0.97%.
Now you know how to calculate the Real Rate of Return over the Nominal Returns of your Investments. Converting Nominal to Real Returns is an important skill to master; even though we earn Nominal Returns, we ultimately get to keep Real Returns.
Until next time, Sweat Your Assets!
Formula:lying on a linear approach, it takes into account the fact that inflation and returns compound over time. If we focus on how investments are doing over the long-t
Annual Return – Annual Inflation = Real Rate of Return