Unit 2 – Time Value of Money
Lesson 2.4: Real Interest Rate & Real Rate-of-Return
You have likely heard the economic term ‘real’ being thrown around in an article or on television — an example of this being Real GDP. ‘Real’ in the world of economics has a different definition than what you would normally use the word for; “affirming actual existence of something or someone”.
No, in this case the word "real" refers to a value that has been adjusted for Inflation.
Before we dive in, it is essential to recap Inflation quickly:
Inflation is the decline of purchasing power of a given currency over a range of time. As currencies lose their value, prices rise, and a given dollar buys fewer goods and services than the years previous. This loss of purchasing power impacts the general cost of living. For example, in 1997 the same amount of milk which would cost you $5, will now cost you $7.38.
This continuous loss of purchasing power leads to lower economic growth. However, to combat the effects of this loss of purchasing power, the central banks around the world take the appropriate steps to manage the supply of money and credit to keep inflation within a certain range.
Why do we invest?
When you are saving, you are choosing to not spend funds in the present to allow you to be able to spend them for a future need. The issue with simply saving the money, is that as time goes on, inflation will eat away at your purchasing power. As many of the goals we save for are way into the future, inflation’s compounding effect makes more and more of an impact as you delay your use of the funds.
The solution to this problem? You need a strategy that will outperform inflation, so that over time, your purchasing power will increase. This is where investing comes in. Whether it is buying a property, purchasing shares in a company, or investing in a fund, individuals are seeking to not only garner returns from these choices, but earning income that outperforms inflation.
Calculating Real Interest Rate / Real Rate-of-Return
When an investor puts their money to work, the rate they expect back from their investment is known as the Nominal Interest Rate. For example, if you currently hold cash in a savings account offering 1%, your Nominal Interest Rate is 1%, per annum. But this is not a complete depiction as to the change of your financial circumstances on an annual basis. We must account for the effects of Inflation. Let’s assume that Inflation is at a constant 2% per year.
The formula to calculate your Real Interest Rate is as follows:
Real Interest Rate = Nominal Interest Rate – Inflation
Real Interest Rate = 1% - 2%
Real Interest Rate = -1%
As you can see, although your savings account seems to be providing you growth each year, your money is losing its purchasing power by 1% each year.
Why Understanding Real Interest Rates are Important
The Real Interest Rate is a critical financial measurement as it will be a more accurate gauge of investment performance than a Nominal Rate-of-Return. Simply put, for you to be better off than you were in the previous time-period, your Real Rate-of-Return must be greater than 0. This reflects the fact that after your investment gain, you are now able to purchase more goods and services than you were prior, even if inflation has increased their prices.
A portion of an individual’s financial plan will encompass the savings and investment strategies that will aid them in accomplishing their future objectives. This is especially significant when saving for longer term objectives due to the compounding nature of Inflation over time. If the financial plan does not account for Inflation, then the individual will save enough to fund an objective, only to find out that once that date comes, the cost of that objective has increased over time, leaving them short of what they need. Inflation isk refers to the possibility of this happening.
One way that a financial plan can address this issue is by accounting for inflation on an investor’s expected Rate-of-Return. By projecting your assets’ growth using a Real Rate-of-Return, you can provide yourself the best opportunity to meet your needs when that day comes.