Investment Returns - Real Rate vs Nominate Rate ?


Investment Returns - Real Rate vs Nominate Rate ?


Which one is better for my investment, Real Rate or Nominate Rate ?

Basically, the return on an investment defined on a Nominal Rate.

So, we have to know, what is a Nominal Rate of Return:

A Bank Fixed deposit gives you a 10 % interest (per annum) for your investment. Then, the nominal rate is also 10 % as it reflects the same. So, there is no need for any deduction from the interest bank pays you.

When the Nominal rate is adjusted with the inflation rate is known as, "Real Rate of Return".

The Real Rate of return helps the investor(s) to adjust with the inflation and getting to know the exact returns on your hand. Let us see the example,

A Bank FD gives you a 10 % interest (p.a) and the inflation rate is at 4 %, then the approximate real rate is:

Nominal rate of return (or) Interest Rate - Inflation Rate


10 % - 4 % = 6 %  (An approximate real rate on easy calculation)

Effects of Real Rate of  Return:



  • Usually, the Nominal rate is a Simple rate (Interest rate), which is always a Positive Rate. But, the Real rate can be Positive or Negative, due to the inflation adjustment. If Inflation rate is higher than the Nominal (or) Interest rate, then it will gives you a Negative rate of return. So as an investor, we should aware about the inflation rate and we cannot simply go with the bank what pays.


 

  • The time value of money reflects the real rate of return. If an investment earns a nominal rate, that is the rate at which the money is being compounded. However, if inflation reduces the actual value of investment cash flows, the value of these returns are discounted by the Rate of inflation. So, we have an idea for the Real Rate of return with a formula,


((1 + Nominal Rate) / (1 + Inflation Rate))  -  1

Lets see,

Nominal Rate:   10 % (i.e FD interest rate)

Inflation Rate:    4 %

(1.10 / 1.04) - 1   =  5.76 %  (As we seen it earlier, approx: 6 %)

The Effect of Real Rate helps in Goal Based Investments, Insurance and Retirement Planning and we can now know the exact rate of amount receive on hands.

RICH INVESTING IDEAS – www.richinvestingideas.com

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