A group of three school friends in their mid- to late-30s decided to meet after 18/20 years. After initial inquiries about career, family, kids, politics, and health, the conversation veered towards money.
'A,' who was the brightest among the three from the school days felt smug and modestly informed his friends that he invests in real estate, where he has made a lot of money. He shared some figures where his initial investment of several lakhs (aided with a bank loan) was now worth more than a crore. Though in terms of value, the figure of gains looks huge, but in terms of return, it was quite average. 'A' was calculating thenominal rate of return over a period of time.
'B,' born with a silver spoon, had joined his father’s business, which was doing very well. He was financially well off and arrived for the friends’ meeting in the latest model of a high-end car. He reeled of some numbers from their family business and went on to state that the effective rate of return his business was yielding after considering all expenses was good enough for him based on the capital invested by the family in their business.
'C,' after schooling and a basic graduation, managed to get a job in a private bank. He had a modest salary with a reasonable year-end performance bonus. However, C had honed the skill of numbers, specifically in the world of investment, returns, rate of interest, and related matters. Even when talking to his friends, he realized that over the next twenty years, as he continues with his chosen investment vehicle, the average real rate of return he expects his investments to yield will probably keep him on par or above his friends in terms of net worth. He knew that the real rate of return his investment yields, combined with the power of compounding, will do magic.
Investors frequently use different types of rates of return to measure their investment’s profitability. The nominal rate of return, the effective rate of return, and the real rate of return are three of the most commonly used rates of return. Let us try to understand what each of these rates of return are and how they differ from each another.
For example, if you invested Rs 1,000 in a stock that earned a nominal rate of return of 10%, you would receive Rs 100 in return, bringing your total investment to Rs 1,100. However, if inflation for the year was 3%, the real value of your investment would only increase by 7%, as the Rs 100 return would only be worth Rs 97 in real terms. Therefore, the nominal rate of return does not provide an accurate picture of the investment's profitability, as it does not account for inflation.
The effective rate of return is the actual rate of return that an investor receives, taking into account compounding and any fees or charges associated with the investment. The effective rate of return is a more accurate measure of profitability than the nominal rate of return since it includes the effects of compounding.
For example, if you invested Rs 1,000 in a stock that earned a nominal rate of return of 10% per year, but the returns were compounded annually, your investment would be worth Rs 1,100 at the end of the year. However, if the returns were compounded semi-annually, your investment would be worth Rs 1,105.02 at the end of the year, which is a slightly higher effective rate of return.
Furthermore, the effective rate of return also takes into account any fees or charges associated with the investment, such as brokerage fees or management fees. These fees can reduce the investor's overall return, so the effective rate of return is a better measure of profitability since it includes these costs.
The real rate of return is the rate of return on an investment after adjusting for inflation. Unlike the nominal rate of return, which does not take into account inflation, the real rate of return provides an accurate measure of the investment's profitability in real terms.
For example, if you invested Rs 1,000 in a stock that earned a nominal rate of return of 10% per year, but inflation for the year was 3%, your real rate of return would only be 7%. This is because the Rs 100 return would only be worth Rs 97 in real terms due to inflation.
The real rate of return is an important measure for investors since it allows them to compare investments on a like-for-like basis. For example, if an investment has a nominal rate of return of 8% and inflation is 2%, the real rate of return would be 6%. If another investment has a nominal rate of return of 6% but inflation is only 1%, the real rate of return would be 5%. Therefore, the real rate of return allows investors to compare investments on a level playing field, taking into account the effects of inflation.
To sum up, understanding the differences between the nominal rate of return, the effective rate of return, and the real rate of return is essential for any investor. The nominal rate of return does not take into account inflation, the effective rate of return includes compounding and any fees or charges associated with the investment, and the real rate of return adjusts for inflation. By understanding these measures, investors can make informed decisions and compare investments on a like-for-like basis
The content made available in this article is for general informational purposes only. While every effort has been made to ensure the accuracy and completeness of the content, it should not be considered as a substitute for professional consultation.
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