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The formula for the real rate of return is one plus the nominal rate divided by one plus the inflation rate, which is then deducted by one. After adjusting for inflation, the real rate of return formula can be used to calculate the effective return on an investment.
The nominal rate, also known as the stated rate or normal return, is the rate of return that has not been adjusted for inflation.
The rate of inflation is estimated using price indices, which represent the price of a group of goods. The consumer price index is one of the most often used price indices (CPI). Although the consumer price index is widely used, when determining the real rate of return, a company or investor may wish to explore using a different price index or even their own collection of commodities that is more relevant to their industry.
Following is the formula to calculate real rate of return:
A person who wants to know how much things they can buy at the end of a year after putting their money in a money market account that earns interest is an example of the actual rate of return formula.
Because the consumer price index is frequently used to gauge inflation, we must assume that the individual wishes to acquire the exact same commodities and proportion of goods that the consumer price index employs in this example of the actual rate of return formula.
The money market yield is 5%, inflation is 3%, and the initial amount is $1000 in this example of the actual rate of return formula. This example would demonstrate the real rate of return formula.
resulting in a real rate of 1.942 percent. Based on today’s prices, an individual with a $1,000 starting balance may buy $1,019.42 worth of products. This example of the real rate of return formula can be verified by multiplying $1019.42 by (1.03), the inflation rate plus one, which yields a balance of $1050, which is the usual return on a 5% yield.
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