March 3, 2020

What Is Meant by the Real Rate of Return?

The real rate of return is a return on an investment that is adjusted for inflationtaxes 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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about the author:

Mike Shorr

Since 1994, Michael has been an on-the-floor market maker, Vice-President of Interest Rate Derivatives for Knight Financial Products and Director of Education and Options Instructor at Trading Advantage. He makes the oftentimes complex world of options and trading accessible to the novice and advanced trader alike. Michael has a Bachelor of Science degree in Statistics and Finance from the University of Illinois Champaign-Urbana. He presently is Director, Trader Education at ProsperTradingAcademy.

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