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What is “Real
Return”?
You may be wondering
just what real return is, and why you should care about it. To put it
simply, the real return on an investment measures “not how many more
dollars are in your account”, but “how much more you can buy with the money
you have”.
Suppose you had $25,000
that you were planning to spend on a car one year from now. The car costs
exactly $25,000, so you’re thinking “Great! I can put my money in the bank
for a year at 1%, earn $250 in interest, and use it to pay for the first
few tanks of gas.” But what if car prices increase by 4% while your money
is sitting in the bank earning 1%? When you go to the dealer to pick out
your new car, now priced at $26,000, you’ll find yourself $750, or almost
3%, short of the amount you need. Sure, you have more money, but it “feels”
like less.
Therein lies the
difference between nominal return (the $250 of interest added to your bank
account) and real return (the balance in your account is no longer enough
to buy the car you wanted). In the example above, your nominal return is 1%
($250/$25,000), but your real return is -2.88% (-$750/$26,000). Now that
sounds like something you should care about.
The same concept can be
applied to any investment, be it a CD, a bond or a piece of real estate, by
simply comparing how much you can buy with the money you get out of the
investment to how much you could have bought with your initial investment
at the time you put it in. Rather than using the price of a single item
like a car to gauge the real value of an investment, it’s more appropriate
to use the Consumer Price Index (CPI) for all Urban Consumers1 published by the Treasury
Department’s Bureau of Labor Statistics, which is a measure of the general
change in prices of the goods and services most people buy.
An investment of
$10,000 at 5% per year (compounded annually) in 1993 would have grown to
$16,289 by 2003. But based on the change in CPI over that ten year period,
the $16,289 buys only as much as $13,269 did in 1993. Your account balance
may have increased by over $6,000, but it feels like a little more than
$3,000. In other words, the nominal return on the investment is 5% per
year, but the real return is only 2.87%.
Or take the same
example above, a $10,000 investment issued with a 5% coupon and inflation
is reported at 3% annually. While you will receive $500 in annual interest
income, inflation has accounted for $300 for a “real” return of only $200,
or 2%.
Locking in a Real Return
Now that you understand
the importance of focusing on real rates of return, what can you do about
it? One approach is to look for investments whose value will move with
inflation. For years, investors have held real assets such as real estate,
gold or other commodities in hopes that their value will increase along
with the general level of prices in the economy. But because the price of
something like a parcel of land can be influenced by many other factors,
this strategy doesn’t always work as planned. Many real assets also take time
to buy or sell, unlike financial instruments that are traded regularly in
the open market.
A better solution may
be to look for financial assets whose return is tied directly to the prices
that you, as a consumer, need to track. Inflation linked investments pay
interest based upon changes in CPI in addition to a fixed coupon rate, and
therefore, provide a consistent and predictable real return. But investors
should be aware that there are structural differences between some of the
inflation-linked products available in the market that can have a great
impact on their effectiveness in combating inflation.
1 Additional information
about the Consumer Price Index can be found at www.bls.gov.
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