What is “Real Return”?

You may be wondering just what real return is, and why you should care about it. To put it simply, the real return on an investment measures “not how many more dollars are in your account”, but “how much more you can buy with the money you have”.

Suppose you had $25,000 that you were planning to spend on a car one year from now. The car costs exactly $25,000, so you’re thinking “Great! I can put my money in the bank for a year at 1%, earn $250 in interest, and use it to pay for the first few tanks of gas.” But what if car prices increase by 4% while your money is sitting in the bank earning 1%? When you go to the dealer to pick out your new car, now priced at $26,000, you’ll find yourself $750, or almost 3%, short of the amount you need. Sure, you have more money, but it “feels” like less.

Therein lies the difference between nominal return (the $250 of interest added to your bank account) and real return (the balance in your account is no longer enough to buy the car you wanted). In the example above, your nominal return is 1% ($250/$25,000), but your real return is -2.88% (-$750/$26,000). Now that sounds like something you should care about.

The same concept can be applied to any investment, be it a CD, a bond or a piece of real estate, by simply comparing how much you can buy with the money you get out of the investment to how much you could have bought with your initial investment at the time you put it in. Rather than using the price of a single item like a car to gauge the real value of an investment, it’s more appropriate to use the Consumer Price Index (CPI) for all Urban Consumers1 published by the Treasury Department’s Bureau of Labor Statistics, which is a measure of the general change in prices of the goods and services most people buy.

An investment of $10,000 at 5% per year (compounded annually) in 1993 would have grown to $16,289 by 2003. But based on the change in CPI over that ten year period, the $16,289 buys only as much as $13,269 did in 1993. Your account balance may have increased by over $6,000, but it feels like a little more than $3,000. In other words, the nominal return on the investment is 5% per year, but the real return is only 2.87%.

Or take the same example above, a $10,000 investment issued with a 5% coupon and inflation is reported at 3% annually. While you will receive $500 in annual interest income, inflation has accounted for $300 for a “real” return of only $200, or 2%.


Locking in a Real Return

Now that you understand the importance of focusing on real rates of return, what can you do about it? One approach is to look for investments whose value will move with inflation. For years, investors have held real assets such as real estate, gold or other commodities in hopes that their value will increase along with the general level of prices in the economy. But because the price of something like a parcel of land can be influenced by many other factors, this strategy doesn’t always work as planned. Many real assets also take time to buy or sell, unlike financial instruments that are traded regularly in the open market.

A better solution may be to look for financial assets whose return is tied directly to the prices that you, as a consumer, need to track. Inflation linked investments pay interest based upon changes in CPI in addition to a fixed coupon rate, and therefore, provide a consistent and predictable real return. But investors should be aware that there are structural differences between some of the inflation-linked products available in the market that can have a great impact on their effectiveness in combating inflation.

1 Additional information about the Consumer Price Index can be found at www.bls.gov.

 

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