Real rate of return

Real rate of return: Welcome to the world of finance, where you can make money while sleeping! But wait, what is real rate of return? It sounds fancy, but it’s actually quite simple. In this blog post, we’ll dive deep into the world of real rate of return, and I promise it won’t be boring.

Real rate of return

Let’s start by understanding the basics

The real rate of return is the rate at which your money grows after adjusting for inflation. In simpler terms, it’s the return you actually make after accounting for the increase in prices over time. For example, if your investment grew by 5% in a year, but inflation was 3%, then your real rate of return would be 2%.

Now, why is it important to know about the real rate of return?

Well, let me ask you this – do you want to lose money or make money? Obviously, the latter. And knowing the real rate of return can help you make informed decisions about your investments, and ensure that you’re actually making money, and not just keeping up with inflation.

Let me give you an example

Say you have $10,000, and you want to invest it for a year. You have two options – Option A offers a return of 5%, and Option B offers a return of 7%. Which one would you choose? At first glance, Option B seems like the obvious choice, right? But wait, let’s factor in inflation.

If inflation is 4%, then your real rate of return for Option A would be 1%, and for Option B it would be 3%. Suddenly, Option A doesn’t seem like such a bad choice after all.

Let’s talk about how to calculate it

Now that we’ve established the importance of the real rate of return, let’s talk about how to calculate it. There are two methods – the Fisher equation, and the approximated method. But don’t worry, I won’t bore you with the nitty-gritty details.

The Fisher equation is the more accurate method, and it takes into account the nominal rate of return (the rate before adjusting for inflation) and the inflation rate. The formula is:

Real Rate of Return = (1 + Nominal Rate of Return) / (1 + Inflation Rate) – 1

The approximated method is simpler, and it involves subtracting the inflation rate from the nominal rate of return. The formula is:

Real Rate of Return = Nominal Rate of Return – Inflation Rate

Both methods will give you the same result (more or less), so use whichever one you find easier.

Now, let’s have some fun with real rate of return

Imagine you’re a time traveler, and you went back to the year 1950 with $10,000. You want to invest it for 70 years and see how much it would be worth in today’s dollars.

If you had invested in the S&P 500, your nominal rate of return would have been around 10% per year. But what about inflation? In 1950, the inflation rate was around 1.09%. Using the Fisher equation, your real rate of return would be around 8.85%.

After 70 years, your $10,000 investment would be worth approximately $2,650,000 in today’s dollars. That’s right, you read that correctly. You would be a multi-millionaire, just by investing $10,000 and waiting patiently for 70 years.

Of course, this is a hypothetical scenario, and past performance is not indicative of future results. But it goes to show the power of compounding, and the importance of knowing your real rate of return.

Conclusion

In conclusion, the real rate of return is a crucial concept in the world of finance. It tells you the actual return you make after taking into account inflation. Understanding the real rate of return can help you make informed decisions about your investments, and ensure that you’re actually making money in the long run.

So, next time you’re considering an investment, don’t forget to calculate the real rate of return. And who knows, maybe in 70 years, you’ll be a multi-millionaire too!

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