Real Return

Definition

Real return is the actual rate of return an investor earns on an investment after accounting for the effects of inflation. It represents the purchasing power gained or lost on an investment over time, providing a more accurate measure of the investment's true performance and value.

5 Must Know Facts For Your Next Test

1. Real return is essential for evaluating the true performance of an investment, as it accounts for the impact of inflation on the investment's purchasing power.
2. Calculating real return requires subtracting the inflation rate from the nominal return on an investment.
3. Real return is particularly important when comparing the performance of different investments or asset classes, as it provides a more accurate basis for comparison.
4. Positive real returns indicate that an investment has outpaced inflation, while negative real returns mean the investment has lost purchasing power over time.
5. Understanding real return is crucial for long-term financial planning and ensuring that investment portfolios maintain their value in the face of rising prices.

Review Questions

• How does real return differ from nominal return, and why is it important to consider real return when evaluating investment performance?
  • Nominal return is the raw percentage increase or decrease in the value of an investment, while real return is the actual rate of return after adjusting for the effects of inflation. Real return is important because it provides a more accurate measure of an investment's true performance and purchasing power over time. By accounting for inflation, real return shows the investor's true gain or loss in terms of their ability to buy goods and services, which is a more meaningful metric for evaluating long-term investment success.
• Describe how the concept of the time value of money relates to real return and the importance of maintaining purchasing power over time.
  • The time value of money principle states that money available today is worth more than the same amount of money in the future due to its potential to earn interest. This concept is closely tied to real return, as maintaining purchasing power over time is a key objective for investors. Real return ensures that an investment's growth keeps pace with or exceeds the rate of inflation, allowing the investor to preserve the purchasing power of their capital. Without considering real return, investors may see their wealth erode in real terms, even if their nominal returns are positive. Factoring in real return is essential for long-term financial planning and ensuring that investment portfolios retain their value.
• Analyze the importance of real return in the context of the historical picture of returns to bonds, and explain how it can inform investment decisions in this asset class.
  • $$\text{Real return} = \text{Nominal return} - \text{Inflation rate}$$ In the context of the historical picture of returns to bonds, real return is a crucial metric for evaluating the true performance of bond investments. Bonds, which are typically considered a more conservative asset class, are particularly sensitive to the effects of inflation. By calculating the real return on bonds, investors can determine whether their bond holdings are maintaining their purchasing power over time or if the returns are being eroded by rising prices. This information can then be used to make informed decisions about the composition of their investment portfolio, potentially adjusting allocations to bonds or other asset classes to ensure their long-term financial goals are met.

Related terms

Nominal Return: The rate of return on an investment before adjusting for inflation, representing the raw percentage increase or decrease in the investment's value.

Inflation:

The general increase in the prices of goods and services over time, which erodes the purchasing power of a currency.

Time Value of Money:

The concept that money available at the present time is worth more than the same amount of money available in the future due to its potential to earn interest.