Difference between Normal Return & Real Return?

When we talk about Normal Returns & Real Returns, Normal Returns are what an investment generates before taxes, fees and inflation. It is simply the net change in price over time whereas Real Returns are the actual value of your returns, typically after adjusting for inflation and fees.

Real Return = Normal Return - Rate of Inflation

The general rule in economics is that the value of money today will not be equal to the same amount of money in the future. Also known as the time value of money, this is a central concept in finance theory, which takes into account factors such as interest rates and inflation. When calculating returns over time, it is important to keep this in perspective and know the difference between normal returns (returns on paper) and real returns (adjusted for today's purchasing power) differ.

Real Return

Can you beat inflation? Certainly. But putting your money in a Fixed Deposit is not the way to go about it. To fight inflation, the key is to invest in a product which gives you a higher rate of interest than inflation, and ultimately leaves you with a surplus to meet your goals. If not, you will find that the value of your investment has actually reduced! Shocked? Let's see why this happens. For example : Let's say your bank pays you interest of 5% per year on the funds in your savings account. If the inflation rate is currently 3% per year, then the real return on your savings today would be 2%. In other words, even though the normal rate of return on your savings is 5%, the real rate of return is only 2%, which means that the real value of your savings only increases by 2% during a one-year period. In addition, if you take into account the tax implications, the real return might be even lower.

For Instance, if you invest Rs. 1,00,000 in a product that offers 12% return that is taxable. The actual tax adjusted rate of return would be

Tax adjusted return | ||||
---|---|---|---|---|

Investment | Rate of Return | 30% slab | 20% slab | 10% slab |

100000 | 12% | 8.40% | 9.60% | 10.80% |

An investment that is giving you 8.4 % tax free return is equivalent to 12% taxable return for a person who is 30% slab. Hence understand the impact of taxation at the time of receiving the return.

So the next time you have money to invest, keep in mind the real return, and not the advertised one. Thus, you might consider investments such as equities, real estate, and commodities which historically have been relatively insured from inflation, as compared to FDs.