Why Real Returns Matter to Your Portfolio? All you need to know
Many economists still have concerns about rising inflation, not just in India but globally. This is because states across countries are experiencing faster-than-expected recovery and quick release of pent-up demand leading to higher inflation. The energy crisis in developed nations and supply chain difficulties in select sectors are already pushing up the commodities prices.
So, how does an increase in inflation affect your portfolio returns? What does all this mean to your investment?
The answer lies in understanding the concept of real returns. Read to know more.
What is a real return?
Real return is the actual return you get after adjusting for inflation. So, if your portfolio returns stand at 10%, considering the current inflation of 4.4%, your actual return stands at 5.6%.
Now, why adjust inflation to the returns made? Well, inflation means an increase in the prices of goods and services over a period. With the increase in prices, your purchasing power reduces. That is, you will be paying higher for the same product over a period. For instance, say you had purchased one kg of sugar for Rs 50 three years ago. For the same quantity of sugar today, you pay around Rs 120.
Essentially, your investment should keep pace with inflation. If your investments grow at 2% every year but inflation rises 3% every year, then you end up losing all the returns you make.
For this reason, you as an investor should consider the real return when you look at your portfolio’s performance. Real return is also known as an inflation-adjusted return.
Further, if your investments are subject to tax, then post-tax returns (returns after adjusting the tax rate) should be considered.
How to calculate real return?
Understanding how to calculate the real return helps you to get a clear idea of your returns. It will also help you to make a better investment choice or investment avenues.
Real rate of return = Nominal interest rate (%) — Inflation rate (%)
Alternatively, you can use an online real returns calculator that is available on multiple websites.
But do keep in mind to choose your inflation rate carefully. Because it plays a key role in achieving your investment objective. For instance, say you are saving now to buy a house 10 years later, then considering the current economic scenario and RBI’s inflation forecasts, you assume a 6% inflation rate. And as per your calculation, your real return, 10 years later, maybe at around 10-12%. If inflation increases around 7-8%, then your portfolio returns might be lower. This means that you might be shorthanded (in terms of funds) to achieve your goal of purchasing a house.
If inflation is too high, your returns could be single-digit or even become negative.
So, make sure to account for inflation every year while calculating your future returns.
Choice of investment to beat inflation
Investors are typically suggested, or perhaps even advised, by many experts to park their savings in asset classes that can beat inflation. Alternatively, investors are told to invest for the long-term (more than a year) to beat inflation.
While it makes sense, it is difficult to find an asset class that beats inflation over a long period, say 10 or 15 years.
Equities or the stock market is believed to beat inflation over time. For instance, between 2015 and 2019, if you had invested in equities, your average returns would have been around 28%. And average inflation was around 6%. So, your real returns would be 22%. If tax is considered, your returns will come down further.
While equities generally beat inflation, it is risky and volatile. There is no guarantee that equities will always beat inflation. In case of a massive sell-off or if there is a correction for years together, then your returns will take a hit irrespective of the low inflation rate.
Therefore, for the sake of higher returns, one shouldn’t go for stock market investment. It can still, however, be a part of your portfolio.
Thus, when you are saving for a future need, do consider all options including gold, fixed deposits, Government and post office schemes and other debt instruments.
To help you achieve your investment goal, it is better to diversify your portfolio. Even if one of the investment options is unable to beat inflation, your portfolio returns don’t collapse.