Real Rate of Return on Investment Calculations
Everyone is interested in the real rate of return of the investments that have been made. However, most investors forget to adjust the rate to inflation and taxes, and as a result don't get real numbers.
So, what they actually calculate is the nominal interest rate. However, the real interest rate is what matters to evaluate the profitability of a particular investment.
Therefore, the real interest rate shows you the growth of your purchasing power, whereas the nominal interest rate shows you the rate of growth of the money you have.
The following example will help you to make a clearer distinction between nominal and real interest rate.
John has invested $2,000. This investment gives a 7% return. So, at the end of the year John will have $2,140 or his money has increased with $140. On the other hand, the economy is experiencing 2.7% inflation rate. So, John's $2,140 is worth approximately $2,086. As you can see, inflation has decreased the value not only of the earnings but also of the principal. As a result, John's real rate of return is 4.3 percent.
The most vulnerable groups to inflation are investors that depend on:
- Dividend income
- Interest from bonds
- Fixed-income securities
Since the gains you receive from a stock are accumulated with time, a useful tactic will be to sell the stock when the inflation rates are low.
Stocks are more advantageous than bonds or other savings instruments in inflation terms since the company can pass the inflation cost to consumers. However, the inflation cycle will not be put to an end and will continue to grow.
In order to receive a real interest rate result you should make the appropriate tax adjustment calculations. This is required since the Uncle Sam will want its fair part at the end of the year.
Let us return to John's example. He has invested $2,000 with a real return of 4.3 % ending him up with $2,086 in real dollars. He still has $2,140 in his account, but the purchasing power of these is equal to $2,086. Let's assume that John is subject to 30% state and federal taxes. So, $42 will go to Uncle Sam's pocket leaving John with $2,098 in his account.
Making the inflation adjustments, $2,041 will be the real purchasing power of John's investment (97.3% of 2,098).
Disappointing? It is! Nominal interest rates are more comforting to investors, but they don't give them a real view on how much their investments are really bringing them. So, don't spare yourself and make the appropriate calculations to see how much your other investments really return you.
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