Nothing to explain much, but a return refers to an appreciation over a principal amount. This what we always expect as a percentage growth from our investments irrespective of how risky are they (Equities) or safe investments like bank fixed deposits or mutual fund liquid fund schemes etc. One of the major factors that affects any investment returns is nothing, but INFLATION. This is invisible, but eat away the real growth of any investment and eventually you may find that the investment has actually grown very less or the growth has been only negative (if inflation is higher than the generated returns). The inflation adjusted returns is called as “Real Rate of Returns” or some time “Real Risk-Free Rate of Return”.
For any long term objectives, you should always consider this factor to know what could the net return on annual basis so that you can decide the right type of asset to choose investing.
How to Calculate Real Rate of Returns
Of course you just don’t have to subtract the expected investment return with inflation, because both long term impact of returns & inflation are of compounding effect, thus simple difference might give you a wrong information.
Formula to be used:
If a risk free instrument generates 8.50% per annum whereas the inflation is at 7.00% then the real risk-free rate of return would be 1.402%, but not 1.50% which could have wrongly calculated by 8.50% minus 7.00%.
As per above formula, the Real Rate of Return or Real Risk-Free Rate of Return is arrived by subtracting 1 from the division of 1 plus the nominal rate (or risk free nominal rate) by 1 plus the inflation rate. Here the nominal rate (or risk free nominal rate) is gross return which is not adjusted with inflation. Such real of of return or real risk-free rate of return can be used to determine the effective return on an investment after adjusting inflation. This become very useful when you have to calculate the expected amount of target to be built for retirement for a survival period so that year of year inflow of income of annuity payouts are envisaged post inflation impact.