Inflation is a risky factor that every income earner must manage. Inflation increases the purchasing power of money that is left in a bank account. Therefore, it is wise to take into account the inflation impact on any investment that earns you a profit. This is the basis for the "real rate of return" metric.
Let's suppose you make a certain percentage of your investments each year. Let's say you consider inflation and adjust your profit to reflect that. This is your'real return on investment'. This metric, as it is defined, can give you an accurate indication of the true purchasing power of any amount earned over time.
Investors can adjust their nominal rate for inflation to determine how much they will be able to purchase purchasing power. This is how they find out how much of the return is actually profit. Inflation is only one of many factors that can reduce purchasing power. Before making an investment decision, investors should consider other factors, such as taxes and investing fees.
This metric will help you to measure your investment returns more accurately. It is possible to calculate it yourself, or you can use one of the many online'real rate calculators'. It's easy to calculate their true purchasing power. This is the real rate of return formula:
Real rate of Return = Nominal Interest Rate (%) -- Inflation Rate (%)
The nominal rate is almost always lower than the real rate. There have been key moments in history when the nominal rate of returns was lower than the real rate, such as when their economy experienced deflation or zero inflation. These moments are not as common as those when investors see inflation reducing their earnings.
Here's an example of how you can use the real rate return formula to calculate your investment returns. Let's say that a bond you plan to invest in pays investors an annual 5% interest rate. This percentage value can be found by performing a quick search on the inflation rate in your country. Let's say that your country has a 3% inflation rate. Therefore, the real rate is equal to the difference of 5% and 33%, which is 2%. Therefore, the purchasing power of that bond is increased by 2% every year, even though it earns 5% interest.
Let's take an example: You had Rs1,00,000. This money was used to buy a car. You decided to save this money and invest it in a 1-year bond investment earning you 5% interest before you go ahead with the purchase. You can still have money after your car is purchased one year later. You will make some profit from the 5% return. At maturity, the profit will be Rs1,05,000 The average car, which used to cost Rs1,00,000.000, would now cost Rs1,03,000. This is despite the fact that inflation increases by 3% every year. Calculating the real rate return can help you determine if the Rs2000 that you'll save by delaying the purchase of your car will be worth it.
The interest rate on investment can be viewed in two ways. One is the nominal interest earned, and the other is the real interest earned. The nominal rate is adjusted for inflation, so the difference between the real and nominal rates is not the same. The reason why the nominal rate of interest is usually higher than the real is because it is adjusted for inflation. You can calculate your real purchasing power by subtracting the inflation rates of your country from the nominal interest you have earned on each investment.