What is the Real Rate of Return?
A real rate of return is a return on an investment that is adjusted for inflation, taxes or other external factors.
How Does the Real Rate of Return Work?
Let's say John Doe opens a savings account that offers a 2.5% interest rate (this is called the nominal rate). This sounds like a nice deal, until you consider the 3% inflation rate and the 28% tax John must pay on the interest. Acccordingly, John's real rate of return is negative (2.5% - 3% loss for inflation – 28% tax on interest income).
Why Does the Real Rate of Return Matter?
It is critical to consider the real rate of return on an investment before investing. Inflation, which is often 2% or 3% per year, reduces the value of money as time passes, and taxes certainly take a chunk away too. What's left -- the real rate of return -- often can be unimpressive after considering these adjustments. Accordingly, investors must consider whether the risk associated with the investment is appropriate given the real rate of return.