The real rate of return is a return on an investment that is adjusted for inflation, taxes or other external factors.
Let’s look at an example:
Let’s say I open a bank account that offers a 2.5% interest rate (this is called the nominal rate). This sounds like a nice deal, until you consider the fact that the inflation rate is, for example, 3% and the 28% tax I must pay on the interest. My real rate of return is negative (2.5% – 3% loss for inflation – 28% tax on interest income).
Why should we care?
The important thing to consider is the real rate of return before making a trade or investment. Inflation, which is often 2% or 3% per year, reduces the value of money as time passes, and taxes certainly take a chunk away too. What’s left — the real rate of return — often can be unimpressive after considering these adjustments. Accordingly, investors must consider whether the risk associated with the investment is appropriate given the real rate of return.
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