Mr Sam wanted to create a corpus for his child’s higher education. He researched and found out that pursuing an MBA degree in a reputed foreign university costs almost Rs. 50 lakhs. Thus, he invested Rs. 5000 monthly in an instrument offering 12% per annum compounding returns for 20 years.
At maturity, Mr Sam had accumulated the desired corpus of Rs. 50 lakhs. However, the same course costs around Rs. 50 lakhs twenty years ago now cost Rs. 75 lakhs because of inflation. Additionally, Mr Sam had to pay approximately Rs. 4.5 lakhs as tax to the government. As a result, the accumulated corpus proved to be insufficient for his child’s education.
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Thus, as an informed investor, you must always consider the real rate of return while making your investing decisions. Continue reading to know the real rate of return and how you can calculate it.
The real rate of return refers to the annual rate of return you’ll get on your investments after adjusting taxes and inflation. The rate of return calculated without factoring in taxes and inflation is the nominal rate of return.
By considering the real rate of return instead of the nominal rate of return, you can determine how much profit you will actually make by investing in an instrument. Apart from taxes and inflation, other factors, such as investing fees, brokerage charges, etc., can also impact your real rate of return.
For example, suppose you are investing in a bond offering 7% per annum returns, and the inflation rate is 4% per annum. It means that your real rate of return is 3%, and your money will grow at this rate every year. However, if you have invested in an instrument offering 3% per annum returns when the annual inflation rate is 4%, you are losing money in actual terms. It’s because even if the value of your investment is increasing, your purchasing power is declining due to inflation.
Understanding how to calculate the real rate of return is very crucial. It will help you determine how much profit you will make in real terms and make informed investing decisions. You can either calculate the real rate of return yourself through a simple mathematical formula or use an online real rate of return calculator.
The formula to calculate the real rate of return is as follows:
Real rate of return = Nominal rate of return – Inflation rate – Tax rate – Investment fee (if any)
In an ideal scenario, the nominal rate of return will always be higher than the real rate. However, in certain circumstances, when the economy undergoes deflation or zero inflation, the nominal rate of return can be lower than the real rate of return. However, this happens very rarely.
You should consider the real rate of return while making investing decisions for several reasons. They include:
When looking at the potential returns you can generate from an investment instrument, remember there are two ways to look at it. You can either look at only the nominal rate of return and make irrational investing decisions or consider the real rate of return and make informed decisions.
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