Definition
The Real Rate of Return is a measure of the profitability of an investment after accounting for inflation. It shows the return on an investment expressed in terms of actual purchasing power, distinguishing it from the nominal rate of return, which does not consider inflation.
Formula:
\[ \text{Real Rate of Return} = \frac{1 + \text{Nominal Rate of Return}}{1 + \text{Inflation Rate}} - 1 \]
Examples
- Investment in Stocks: If you invest in stocks and earn an annual return of 7%, but inflation is 2%, the real rate of return would be approximately 4.9%.
- Bonds Investment: A bond yielding 5% annually when the inflation rate is 3% will have a real rate of return around 1.94%.
Frequently Asked Questions (FAQs)
Q: Why is the real rate of return important? A: The real rate of return provides a more accurate measure of the actual purchasing power gained from an investment, which is crucial for evaluating its true profitability over time.
Q: How does inflation affect my investments? A: Inflation erodes the purchasing power of money; hence, the returns on investments should be adjusted for inflation to understand the true value.
Q: Can the real rate of return be negative? A: Yes, if the rate of inflation exceeds the nominal rate of return, the real rate of return will be negative, indicating a loss in purchasing power.
Related Terms with Definitions
- Nominal Rate of Return: The percentage gain or loss on an investment unadjusted for inflation.
- Inflation Rate: The rate at which the general level of prices for goods and services is rising, eroding purchasing power.
- Purchasing Power: The value of a unit of currency in terms of the goods or services it can buy.
Online References
Suggested Books for Further Studies
- “Investments” by Zvi Bodie, Alex Kane, and Alan J. Marcus
- “Principles of Corporate Finance” by Richard A. Brealey, Stewart C. Myers, and Franklin Allen