Real Rate Of Investment Return

I was talking to a friend recently and made reference to the real rate of investment return and had the thought that it would be a very useful concept for anyone who hadn’t encountered it before. Basically the real rate of return is the annual rate of return on an investment minus inflation.

For example, stocks apparently average around a 10% return over a long period. With 3% inflation, we’d say the real return is 7% (10% cash in your pocket minus 3% lost to inflation). If you’re happy about the 5% you recently got on a GIC, the real return on it would be 2%.

You might ask, “Why do I care what the real return is? The money I get is cash in my pocket!” Great question. You care because you won’t get the cash until a later date. The real return tells you what that money will be worth in TODAY’S DOLLARS at that later date. Its easier to calculate your return in future dollars, but it can be hard to shift gears and realize a dollar is worth less in the future than now.

Suzy Orman (among others) loves to tell people how much they’ll have when they retire if they save $X amount. Say you inherit $5,000, invest it an index fund returning an average of 10%. When you retire in 30 years, you’ll have $87,247.01 (5000*(1.10)^30) they say and you’re suitably impressed. What is $87K worth 30 years from now though? Given that a movie will probably cost $25 bucks, it wouldn’t go as far as $87K would today.

A comparable investment would have a real return of $38,061.28 (5000*(1.10-0.03)^30). This is $38K which would buy $38K worth of goods today (so basically after 30 years the $5K investment will give you enough to live a pretty respectable lifestyle for a couple of years, enough to buy two nice cars or enough to take a number of pretty deluxe vacations – about 7 times the buying power of the $5K today).

I like to do all my investment projections in real returns (as Bernstein recommends). This lets you factor inflation into your plans, yet still understand at a glance what sort of buying power your money will have.

You can use all your current numbers for expenses, and if you’re comparing them to the real return of your investments you don’t have to do anything else. For example, my current living expenses are around $1200 / month. If I’m working with real returns, I can use this as my living expenses when I’m 65 and it will still be valid (I can compare expenses in today’s dollars with returns in todays’ dollars). Otherwise I’d have to adjust my expenses for inflation to compare it to future dollars.

E.g. my $1,200 expenses would be $2,912.71 (1200*(1.03)^30) 30 years from now (after inflation). The $87,247.01 above would pay for my living expenses for 29.95 months (87247.01/2912.71). The real return would cover my expenses for 31.72 months (38,061.28/1200). Basically the same results (living expenses for 2.5 years), but much easier to calculate. The difference is due to rounding errors and the fact that 1.07*1.03 ~= 1.10 (but not exactly). No one can tell you exactly what the market returns or inflation will be over the next 30 years so all these predictions are far from certain (and a slight difference between the numbers isn’t a big deal – these AREN’T precise calculations).

Clear as mud? If anyone thinks they can explain this better than I have, feel free to take a shot at it in the comments or link to better explanations (I won’t be offended 🙂 ).