Return in finance/ banking parlance is defined as profit or loss from an investment. To put it in simple words, Return is the amount earned or lost on every single Rupee of investment over time. Now, what exactly is Real Return and why investors should take it seriously.
Real return is the actual return received in hand by the investor after providing for taxation and inflation. Or in simple terms, Real Returns is the return post tax and post inflation. Most of the time investors ignore the effect of taxation and inflation on their investment returns.
Let us take a look at the example below for better understanding: –
An investor in the 30% income tax slab invests Rs 100/- in a bond earning 7% return per annum. Ideally the investor should be receiving Rs. 107/- at the end of year one. However, in reality this is not true. On the Rs. 7/- interest earned, the investor has to pay a tax of Rs. 2.10/-. Which means, the investor only gets Rs. 4.90 in hand reducing his effective returns from 7% to 4.9%.
However, this does not end here. We have still not accounted for inflation during the period. Let us assume an inflation of 5% per annum during the prevailing period (which can be related to Indian situation), the Rupee has got devalued by 5% in the same period. Which implies, Rs. 100/- one year back is today only worth Rs. 95/-.
Now in the above example, did the investor make or lose money? On his investment of Rs. 100/-, his effective in hand returns in absolute purchasing power terms is (Rs. 95.00 + Rs. 4.90) only Rs. 99.90/- after accounting for taxation and inflation, which is nothing but a straight loss.
The stated return on the above investment proposal was 7% per annum. However, the investor’s Real Return was -0.1%. Hence, if the investor continues to invest in this product, he continues to earn negative returns and lose money year on year.
The above example has made it amply clear as to why one should always look at Real Returns before choosing an investment. Ignore Real Returns and you can be certain of poverty. Knowing that will be the difference between working for money and making money work for you. Remember…..An educated investor is a successful investor.