At a minimum, investors should understand what real and nominal returns of an investment are. As opposed to nominal returns, which only have to do with the gross behaviour of an investment, real returns are a more precise estimate of the real contribution of an investment, after the impact of inflation has been taken into account. This disregard of inflation when calculating returns can lead to an overvalued figure of growth in net worth of consequence for fund and long-term target.

What Are Nominal Returns?

Nominal returns are the investment returns, uncorrected for inflation. This is the chart with which you will be constantly forced to deal every time you read the investment performance reports or fixed deposit and bond interest rates. They are shown as a percentage, representing profit percentage made in that period on your investment.

E.g., if you deposit ₹10,000 in the fixed deposit scheme with 6 per cent annual simple interest, the simple interest at the end of the 1st year would be:

Nominal Return=₹10,000 x (6/100) = ₹600.

Thus the final value of your investment at the year-end will be 10,600. Especially if this number does not match the rise in cost of goods and services because of inflation.

What Are Real Returns?

Real return is the return an investor attains, taking into account the inflation effect. This counterpart can also give you a more accurate sense of the degree to which purchasing power you have gained or lost with your investment. Real returns tell us whether your investment is actually increased in value or just rose in line with price increases.

The formula to calculate real returns is:

Real rate of return = Nominal interest rate (%) — Inflation rate (%)

For example, when the annual inflation rate is 4% where the rate of return you have received from a fixeddeposit is 6%,real rate of return becomes:

Real Return = 6% – 4% = 2%

On the other hand, since your investment, in the strictest sense, has a nominal annualized return rate of 6 percent, the fact (a measure of the real expansion of the purchasing power) is extremely low, only 1.92 percent, after the impact of inflation is considered. Therefore, although the sum of your money aggregated, the purchasing power increased only in a marginal way.

Why Is Adjusting for Inflation Important?

• Preserving Purchasing Power: Inflation erodes the purchasing power of your money and, as a result, the value of money. If the returns from your investments are less than the inflation rate, perhaps you will be in a situation where the money you have now can purchase you less in the future than it can currently. Specifically, if the investment yield is 5% while the inflation rate is 6% (i.e., the result of the evaluation of the nominal money supply), in the end, you are actually losing the real value of “real money.

• Making Better Investment Decisions: Real return comprehension allows it to be a more rational comparison between the various investment products that are on offer. For example, while an FD can also promise a stable nominal rate of return of 6%, a mutual fund offering a 10% nominal rate of return with an even greater real rate of return after inflation is accounted for, may be a better balance for long term wealth accumulation. In doing so, it permits you to make investment decisions by and for their expected (or lack of) ability to generate real world wealth.
• Planning for Retirement: Also, it is important to consider the inflation coefficient when considering larger monetary goals, e.g., retirement. In predicting the final amount of money one will have in retirement, the underlying phenomenon of the cost of living growing through time also needs to be taken into consideration. However, if you do not take the effect of inflation into account, you will not save enough and the difference in the amount of retirement income could be.

Investment in fixed income (bonds and fixed deposits) is also vulnerable to inflation. When inflation pushes the bottom of the crawlspace, the real returns on these assets can be negative despite positive nominal returns. For example, while the bond yields 4% at 5% inflation rate, the real rate of return is also -1% (i.e., your buying power truly will go down).

Real-Life Example: Understanding Real Returns in India

Let’s consider an example from the Indian market. Let us assume that you make an investment in a Public Provident Fund (PPF) with an interest rate of 7% per annum. If the inflation rate in India is 5%, the real yield of PPF would be:

Real Return would be around 2%

This equation demonstrates that, after accounting for inflation, the rate at which your investment in the PPF reduces the purchasing power of the populace is growing at roughly 2% per year. Although this is a desirable increase, there is a suggestion that it is worthwhile to consider inflation when economic return of an investment is used as a metric.

Strategies to Beat Inflation and Maximize Real Returns

• Invest in Mutual Fund & Equities: Historically, returns for equities (stocks) have shown to outperform fixed-income assets returning real return to a greater extent. In the long run, stock will outperform inflation, stock is a major component of, an actively managed investment portfolio.

• Consider Real Estate: Real estate possesses the potential to be a potent inflation hedge, as both the value of the property and the (rental) income are expected to grow at the rate of inflation. Yet market situation, along with site and demand should be considered before an initial commitment is made.
• Gold as a Hedge: Gold has always been thought to be a store of value, especially in high inflation settings. Although gold may not generate income flow, gold can serve as a reserve to absorb losses in the purchasing power of monetary paper money resulting from inflation.
• Inflation-Indexed Bonds: Certain government bonds, e.g., Inflation-Indexed Bonds (IIBs), introduce exposure to the evolution of the level of inflation without explicit intermediate variables. These bonds, again, recomputed the principal value in terms of inflation and subsequently are useful also for investors, so as to verify their purchasing power.
• Diversification: The construction of a diversified portfolio with a variety of asset classes also has the effect of balancing risks and produce returns higher than inflation. This approach ensures that, in spite of suboptimal performances at an inflation, there will be assets that have a better real value in the deregulated period.

Conclusion

The difference between nominal and real return is in most need of attention in effective investment planning. Even though, at first glance, the observed potential of the nominal returns is large enough, inflation needs to be taken into account, if the story is to be complete. When real returns are used for it is not only easier to measure growth of your assets, but also to preserve the purchasing power and to make strategic decisions in accordance with the financial goals. No matter whether you are saving for retirement, buying a house or saving a fund for a family, paying attention to inflation and real returns may be just what you need in order to achieve financial success.