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How to calculate real returns

Factoring in inflation – which might not be inflation as you know it.
Looking at what inflation is doing to something you can actually buy is a useful way of grasping what your real return is. Image: Shutterstock

We need to get real. As much as we would like to keep all of the return our investments generate, the reality is that inflation secretly steals some of that return.

Okay that was really bad. Doh.

Right, let’s try that again …

Knowing your real return is important, because it represents how much better off you are after you factor in the eroding effects of inflation.

Remember that a return of 20% might sound phenomenal, but if inflation is also 20% it means you haven’t made any progress (and if your return was less than 20% then you are actually getting poorer).

How to calculate real returns

Let’s start with an example. If you managed to get a return of 9%, and inflation is 5%, what would your real return be?

A commonly used method for calculating real return, is to take the return you get and simply subtract inflation.

Real return = Return – inflation

So in our example:

Real return = 9% – 5%

Real return = 4%

This intuitively makes sense – you want the return after inflation, so just take away the inflation part.

Now this is not a bad start, and there are many people who (possibly dangerously) use this as the actual real return. But this method is actually not 100% correct and should only be used as an estimation.

Okay, so how do you calculate the actual real return?

Let’s continue using our 9% return, 5% inflation example …

Let’s say you had R100 (you baller you) and coincidentally, a widget also costs exactly R100. Using some advanced maths, you can work out that your money can buy you precisely one widget.

Now, let’s say instead of buying a widget with your R100, you invested it and got a 9% return. After one year, you will have R109. In that same year, inflation (at 5%) results in the price of the widget increasing to R105.

So that means you can now buy R109/R105 = 1.038 widgets.

In other words, in widget terms (what your money can actually buy), you are 0.038 widgets (or 3.8%) better off than you were in the previous year. And this measure of how much better off you are is – yes, you guessed it: your real return.

So in this example, your real return is 3.8% (and not quite as good as the 4% previously calculated).

Let’s get into some maths and formalise the above example. The correct way to calculate real return is as follows:

Okay, so that’s cool and all, but what’s the big deal? Can’t we just use the estimated real return (which is a lot simpler to calculate)? Does the difference really matter?

Well, in lower-inflation, lower-return environments like the US and Europe, it actually doesn’t matter that much.

For example, with returns of 5% and inflation of 1% (plug it into the formula above if you want to practice):

Estimated real return = 4%

Actual real return = 3.96%

That’s no biggie.

But in high-inflation, high-return environments (like the good old RS of A), the difference is bigger and can affect planning and projections, especially over the longer term.

For example, with returns of 12% and inflation at 8%:

Estimated real return = 4%

Actual real return = 3.7%

That 0.3% difference doesn’t seem like much (and over one year it isn’t), but over time it starts creating a significant gap between the estimated and the actual investment balance. This can really mess with any long-term planning and projections you might be running:

What’s your inflation rate?

In the above examples it was pretty quick and easy to claim inflation is 5% and happily math away. But in reality, what is the inflation value you should use? This is an important question, because inflation will directly impact your real return – the higher inflation is, the worse your real return is going to be.

Of course you could use the nice broad average annual inflation rate of the country which is published by Statistics SA. Although this value is useful, it can also be a little dangerous – because it is unlikely that it represents inflation as you experience it.

So, for that reason, something I like to keep an eye on is my own personal inflation rate. I then use that value when calculating real returns.

If you are interested in calculating your own personal inflation rate, check out this article and free spreadsheet download which can do the number crunching for you.

Till next time, stay stealthy!

COMMENTS   6

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Great article, superbly explained. It even mentions the inaccuracy of inflation rate calculations by Stats SA. Peter Schiff even mentions it in his most recent podcast; how the USA disingenuously calculates the inflation rate to make figures look better.

Thank you very much for the great practical useful information, very much appreciated. Could we please also have practical calculations associated to investing in shares based on published company results, bond buying and Kruger Rands.

Good article…except that we have had a false infl rate declared for decades as well as stealth inflation. There are no real returns. All financial planning based on 4% even 6% is of no value. Break through the cognitive dissonance and biases then you see the real picture.

Here is an even worse case of Real Return used as a marketing gimmick

For years Asset Managers use a Benchmark of CPI + X as a way to communicate the targeted nominal return of a fund, in order to give a meaningfull real return.

If they met their target, as Stealthy explained, you actually missed the real REAL return.

However,

Let’s assume the said fund targeted CPI + 5
30 Years Ago: 14.43 + 5 = 21.43
20 Years Ago: 7 + 5 = 12
10 Years Ago: 3.34 + 5 = 8.34
Now: 3.97 + 5 = 8.97

Now, 30 years ago, the Asset Manager needed to outperfom inflation by 35% to achieve the target, now, they need to outperform by 126%

Year in and year out. I think not. Yet everyone and his dog is getting a financial plan drawn up with this CPI + x as an assumption. No one will ever achieve that consitently.

Nice technical article…good thing to brush up old varsity knowledge!

Now, please EXPLAIN THAT TO SARS when it comes to calculating CGT gains!!!

Say you buy a rental property in 2001 for R300,000. Now you sell this (non-primary) residence for R800,000 nineteen years later.

CGT gain is R500,000 (for sake of simplicity, ignoring the annual R40K exemption & any relevant acquisition costs, or improvements).

Yet today’s value of R800K is the figure you get when you add 5% per annum INFLATION growth to the original R300K asset over 19 years. Meaning, for R300K back in 2001, it would buy you THE SAME GOODS & SERVICES as R800K TODAY.

So WHERE is the so-called “gain”. NO wealth was created.

Time for all SARS top-level staff to attend a “real return” seminar with Stealthy Wealth ;-)(…and charge them heavy fees!!)

…to re-emphasize: the purpose of CGT tax is to tax (actual) gains on wealth creation. Fair enough.

In many examples like these, the (real) capital gain may likely be zero or neglible when inflation is taken into account over the longer term.

Little or no (real) wealth was created, why tax it? A “gain” is surely an indicator of (real) wealth, not so?

Hence SARS taxes citizens (mostly) on a face value number which is nothing more than a pure inflation differential.

(……and yet SARS accept the impact of inflation, by charging INTEREST on arrear assessed accounts. SARS is having its cake AND eat it! Would be nice to pay any relevant assessed tax in 20 years’ time…surely, like CGT, it would be the SAME figure ignoring interest 😉

End of comments.

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