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.
You can do the manual calculation as follows:
Total Inflation Rate = (Cost of Item 1)/(Total Expenses)x(Inflation Rate Of Item 1) +
(Cost of Item 2)/(Total Expenses)x(Inflation Rate Of Item 2) +
… etc etc.