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What is Real Rate of Return?

Real rate of return is a notion that takes factors such as inflation and taxation into account before reporting a realized rate of interest on an investment.

Economic theorist Irving Fisher first popularized the idea that there is a difference between a nominal interest rate and a real interest rate. Consider a bond that pays a steady coupon rate of 2% for the next 10 years.

If inflation is more than 2%, the real rate of return on that investment is negative. If the investor got taxed on the nominal gains, the real rate of return is pushed further into negative territory.

Long-term investors can obviously benefit by looking at real rate of return in addition to just discount rates or expected rates of return. If a market investment earned 6% over 20 years, but the average inflation rate during that time was 4%, the real rate of return is only 2%.

Inflation rates are determined using price indexes on consumer goods, and this gives investors a sense of how much their money will be worth in the future. Any rate of return is better than none, but stocks are the only asset class that has consistently outpaced inflation historically.

Real rate of return can encourage investors to step outside of their comfort zone, which could be a good thing or a bad thing if they don’t have the risk tolerance for it.

Keywords: risk tolerance, inflation, bonds, discount rate, taxes, buying power, time value of money, coupon rate, assumed rate of return, guaranteed rate of return, after-tax yield, long term financial planning, Consumer Price Index (CPI), real rate of return,