Real Rate of Return: Meaning, Formula & Importance

Real rate of return is the annual rate of return taken into consideration after taxes and inflation. However, a rate of return that does not consist of taxes or inflation is referred to as a nominal rate.
Likewise, a rate of return that includes taxes or inflation in its calculation is the real rate. The real rate of return is what the investor will receive after making any investment.
Other calculations might give you a bigger, more appealing rate of return on your investment. But those don’t take inflation into account because they rarely look at what you’ll be getting after taxes.
These numbers can have a serious effect on whether an investment will be worth it for you or not, especially if you are comparing it against other potential investment opportunities.
You could also add other factors into your calculation that take money off the top of your return’s value.
For example, a bond pays an interest rate of 5% per year, and the inflation rate is 3% each year. The bond’s real rate of return is 2%, meaning the investment’s value is only growing by 2% each year.
If your investment increases by 1% and the rate of inflation is 2%, you're actually losing money in real terms, even though on the face of it your investment has gone up in value. Because the cost of living has gone up by 2%, it will cost you more to buy the same things. The fact that your investment hasn't kept pace with the inflation means you'll actually be worse off.
For this reason, it's important that you consider the real rate of return when you're taking a look at the performance of your investment.

Understanding how to calculate the real rate of return will give you a clear idea of the returns on your investments. You can either calculate the rate of return all by yourself or select among several “real rate of return calculators” available online.
The formula for real rate of return is:
Real rate of return = Nominal interest rate (%) — Inflation rate (%)
However, the nominal return rate is always higher than the real rate of return. There are some crucial instances in the financial history where nominal return rate was lower than their real rate as their economy saw deflation or zero inflation.

There are several benefits of why you should be calculating the real rate of return of your investment. So let’s look at them given below:
1) It helps you in knowing the actual return your investment is generating. Thus, you can see beyond what is visible to the naked eye. This ultimately stops you from building castles in the air. Further, when you know the true picture, you can build your portfolio in accordance with that.
2) The real rate of return adjusts profit for the effects of inflation. It is a more accurate measure of investment performance than nominal rate of return. Nominal rates of return are higher than real rates of return except in times of zero inflation or deflation.
3) Rate of return (ROR), or the rate of profit (ROP), is a crucial measure of how lucrative an investment is. It indicates whether an investment is viable or not and how efficient it is.

It is important to consider the real rate of return on an investment before looking to make an investment. In today’s time inflation rate is 5.7%, which means it is reducing the value of money as time passes by and taxes certainly take a chunk away too.
What's left -- the real rate of return -- often can be unimpressive after considering these adjustments. Accordingly, investors must consider whether the risk associated with the investment is appropriate given the real rate of return.

Conclusion

When you are looking at the interest rate after a particular investment, remember there are two ways of looking at this number, the nominal interest earned and the real interest earned.
However, the major difference between both the interest rates is that the former is adjusted for inflation. This is why, most of the time, one’s nominal rate of interest is always higher than the real rate of interest.
To know the exact purchasing power, you can calculate the real rate of return by subtracting the inflation rate of your country from your nominal interest earned on any single investment.

• What is the Real Rate of Return?

Real rate of return is the annual rate of return taken into consideration after taxes and inflation. However, a rate of return that does not consist of taxes or inflation is referred to as a nominal rate.

• What is the major benefit of real rate of return?

The real rate of return adjusts profit for the effects of inflation. It is a more accurate measure of investment performance than nominal rate of return. Nominal rates of return are higher than real rates of return except in times of zero inflation or deflation.

• What is the formula of real rate of return?

The formula for real rate of return is:
Real rate of return = Nominal interest rate (%) — Inflation rate (%)

• What is the major difference between real rate of return and the nominal rate?

However, the major difference between both the interest rate is that the former is adjusted for inflation. This is why, most of the time, one’s nominal rate of interest is always higher than the real rate of interest.