Ever wonder if getting higher returns on investments than the return you get on money you keep in your savings account is enough to secure your future.
Finance experts say investing in different asset classes is the best way to grow your money with time, but this concept has a second layer.
The second layer is inflation, and if you’re an Indian investor, you need to keep in check the inflation rate in India.
The second layer becomes crucial because, with the rise in your investment nominal rate of return, we need to see that the inflation rate in India is also rising.
We need to make sure that the return on our investments is growing higher than the inflation rate in India.
So, we should focus more on the real rate of return than the nominal rate of return; let’s get these concepts clearer.
What is the real rate of return?
The real rate of return is the actual return you get after adjusting for inflation and taxes. The nominal rate of return does not include taxes or inflation.
For example, If your investments give you a return of 15% and the inflation rate in India is 5%, then your actual return on your investment will be 10%.
According to the real rate of return, the actual purchasing power of a given amount of money is determined over time. As prices increase, your purchasing power decreases.
This is because you will be paying a much higher amount for any product you buy today at a low price.
For the train ticket for which you are paying Rs 500 today, five years from now, you will be paying 1000 for the same train ticket.
It is essential to keep the concept of real vs nominal returns in mind whenever you are investing your money.
It is crucial to keep your investment up with inflation.
During a period of high inflation, calculating the rate of return in real value rather than nominal value is more helpful in determining whether an investment was successful.
So, it is crucial to calculate real return before selling or tracking your investment.
What is the significance of the real rate of return?
We know that one of the main motives of our investments is to meet our financial goals.
Let’s say you want to buy a car five years later, considering the RBI’s inflation forecasts and other economic factors, and you can assume that the inflation rate in India will be 7%.
Now, as per you and your financial advisor, the real rate of return will be 15%.
Now let’s suppose if the inflation rose to 10%, then your investment will not be able to fulfil your financial goal to buy that car.
The nominal rate of return might turn out to be negative in real value if the inflation rate in India rose very high.
The real rate of return provides you with information on the actual return that your investment is generating as an investor.
It stops you from building castles in the air. By assessing the real position of your investment, you can design your portfolio accordingly.
The concept of real vs nominal returns opens our eyes as an investor.
The late 1970s and early 1980s were a good example of a potential gap between nominal and real rates of return.
This period saw double-digit growth in investments, but at the same time, In 1979 and 1980, prices increased by 11.3% and 13.5%, respectively.
This literally wiped out all the positive returns in real value.
It is essential to calculate the real return to know the actual picture of your investment.
In terms of historical performance, real rates give an accurate picture of any asset class and help you to meet your financial goals.
Also Read: Financial ratio analysis that every stock investor should know
Which investments can give you better real returns?
Keeping in mind the inflation rate in India, a financial advisor tells investors to maintain a diversified portfolio, keeping all the asset classes in your portfolio.
The concept of real vs nominal returns briefly tells us how the nominal rate of return depicts an inaccurate picture of any investment.
It is important to calculate the real return, but it is equally important to hold your investment for the long term to get a better real rate of return.
One of the best options is equities. Between 2015 and 2019, the market gave an average return of approx.
28%, now that is a lot because the inflation rate in India was around 6%. Investments in equities would have made you a real return of 22%.
Irrespective of this fact, historical data also suggest that equities are very volatile too, and a big correction in the market can also turn the table for your investments.
It is advised not to totally depend on equities, but it can be a major part of your asset class portfolio.
When it is advised to calculate the real return, we talk about the real rate of return consisting of various asset classes like gold, fixed deposits, government bonds, and equities.
Keeping the concept of real vs nominal returns in mind, where we discussed why to avoid the nominal rate of return for your investment.
It becomes crucial for us to maintain a well-diversified portfolio to keep the inflation rate in India in check.
Conclusion
It is important to keep in mind that there are two ways to look at the interest rate after an investment: the nominal interest earned and the real interest earned.
The major difference when you calculate real return and nominal rate of return is that the nominal rate does not consider inflation and taxes into account.
This is why the nominal rate of return is always higher than the real rate of return.
We need to consider the inflation rate in India in mind whenever we have a desire to meet any of our financial goals.
The real rate of return gives you the exact idea of your purchasing power.
When taxes and investing fees are taken into account, the real rate of return becomes much more accurate.
More than anything, to beat inflation in the future, you have to maintain a well-diversified portfolio consisting of all the major asset classes.
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