The nominal rate of return refers to the annualized percentage gain on your investment without considering the inflation and taxes. When inflation is considered in the nominal rate of return, the adjusted values are known as the real rate. It is quite difficult to understand the raw definition and difference between the real rate of return and nominal rate owing to its complexity. Therefore, let us try to understand the same with the help of an example –
Real Rate of Return – Example
Suppose you wanted to buy a car at the beginning of the year priced at Rs. 5,00,000. However, you deferred your decision for a year and invested the same amount of money in a Bank Fixed Deposit. After 12 months of your investment, the amount of Rs. 5,00,000 increased to Rs. 5,35,000 (assuming interest rate of 7%).
What do you think? Would you be gaining around 35,000 by purchasing the car for Rs. 5 Lakhs? The answer to this question is a big NO. Why? Because we have not considered inflation i.e. the rate of increase in car prices.
Let’s make the assumption that the price of the car has also increased by 5% due to inflation. This simply means that the car price would be Rs. 5.25 lakhs next year. Moreover, your investment has grown to 5.35 lakhs while the car is still priced at 5.25 lakhs. But does that mean you will gain a profit of Rs.10000? The answer is NO. Before coming to the explanation for the answer, let us calculate the real rate of return with the above-mentioned example.
So, the amount of money that’s left after buying a car (after 12 months) is the real rate of return. Here, 7% is the nominal rate of return whereas the inflation is 5%.
In this case, the real rate of return is 2%.
Investment Value After 12 Months – Rs. 535000
Car Value After 12 Months (considering inflation) – Rs. 525000
Real Return – Rs. 10000
% Real Rate – (Rs. 10000/Rs. 500000)*100 = 2%
% Real Rate of Return – Nominal Rate – Inflation= 7%-5% = 2%
This is the simplified formula.
Please utilize the below-mentioned formula to calculate the real rate in the same way.
Also Read: How inflation and returns impact your goals?
Real Rate of Return Formula
Real Rate of Return Formula = (1+Nominal Rate/1+inflation) * 100 = 107/105*100
(Since the nominal rate is 7% and the rate of inflation is 5%, the values are taken as 107 and 105.)
So, in the above-mentioned example, the real rate of return would be 1.9%.
If you include taxes in it, the real rate of return would be reduced even further.
Including Taxes in Real Rate of return
Let us take the aforementioned example and assume that you are in the 30% tax bracket. Suppose you have an earning of Rs. 35000 in the fixed deposit of a bank. This will make you liable to pay Rs. 10,500 as taxes.
Tax on Fixed Deposit = 35000*.30 = Rs. 10500 (I have not considered any surcharge on tax.)
Total Investment After 12 Months = Rs. 5,35,000 – Rs. 10500 = Rs. 524500
In this particular scenario, your purchasing power has been reduced. So after 1 year of making the investment, you are still shelling some extra money from your pocket i.e. you are actually purchasing the car at higher price.
Hence, it is preferable to buy a car now instead of deferring it for an entire year.
If the investment rates and inflation rates are in a very close range, the real rate is low. (i.e. your purchasing power remains the same).
If the nominal rate of return is much higher than inflation, it’s better to defer the decision to purchase.
If the nominal rate of return is much lower than the inflation rate, it’s better to make the purchase now.
But sometimes, even the real rate doesn’t give the right picture. There’re chances of calculating returns on a higher side when you invest in equity instruments like mutual funds or stocks.
In fact, there are chances of calculating inflation on the higher or lower side. Like in the above-mentioned example, general inflation can be somewhere in the range of 5%. However, car prices may show inflation of 3% only.
Both nominal and real rates of returns have their own pros and cons.
Difference between Real Rate And Nominal Rate
In a nutshell, the nominal rate of return is when inflation and taxes are not adjusted in the investment returns.
Whereas the real rate is when inflation and taxes are adjusted in the investment returns.
Please let me know if you have any other queries regarding the real and nominal rate of returns.
Till Then, Happy Investing!