EVALUATION OF REAL RATE OF RETURN
People generally make this mistake that they calculate their rate of return of money by simply calculating the money they have earned through investment in one year. But the value calculated is not the real return of money as they have not deducted the inflation and taxes.
The nominal return of money and real return of money are not similar. Nominal return rate show you the amount you have generated from your investment while the real return rate of money tells exactly how much purchasing power you have.
With the help of following example, you can easily understand the above statement.
Let’s suppose, one has invested $1000. The money is growing by 10% annually so; you will end up with a profit of $100 in the end of the investing year. Now you will have to deduct the inflation rate from your return rate. Suppose the inflation rate for that year is 4%. It will lower the worth of your $1100 to $1056 (1100 – 44). Inflation rate not only degrades your profits but also the investment you have made. So the real interest percentage falls down to 6% from 10%.
It is an important think to consider that the investors who invest in bonds or similar type of fixed income securities etc. are more affected by inflation cost. But those who hold stocks can protect their earnings from degrading through inflation rate. This can be done by properly timing the selling of the stocks. The inflation growth is better avoided in stocks than fixed income securities. Large firms sell their stocks to their clients after adding the inflation cost. The stock holders will sell them further at higher price, thus increasing inflation.
This would be real rate of money return only if your investment is tax free. So, for achieving the value of real return rate, you must also subtract the taxes from return rate. This would be the part of your income that is shared by the government as well in the name of taxes.
Just getting back to the previous example, we will tell you about the calculation of real rate of money return after deducting government taxes. The investment was $1000 which grows to $1100 after a year. The growth rate was 10%. Due to 4% inflation rate, the amount was reached to $1056. Let’s assume that you deduct 28% of taxes in total including federal and the state taxes. Out of $100 interest, the remaining amount will be $72 leaving your amount to 1072. When we subtract 4% of inflation amount. It will go down to $1029.12 (4% of 1072 is $42.88).
This shows that by investing $1000 for one year, you got only 2.91% rate of return i.e. your purchasing power has increased by 2.91% only over a year. The conclusion that we have derived from the above example is that the real monetary return rates are not that much attractive as we think it to be. That’s why the term nominal “rate of monetary return” is used to attract investors.