Understanding Real Returns: The Key to Inflation-Proofing Your Investments

Rising inflation continues to be a global concern, impacting economies far beyond India. As countries recover faster than expected, the release of pent-up demand is driving inflation higher. Factors such as energy crises in developed nations and supply chain disruptions in key sectors are further inflating commodity prices.

But what does this mean for your investments? How does inflation influence your portfolio returns? The answer lies in understanding the concept of real returns.

What Are Real Returns?

Real return refers to the actual return on your investment after adjusting for inflation. For instance, if your portfolio returns are 10% but the inflation rate is 4.4%, your real return is only 5.6%.

Why is adjusting for inflation important? Inflation reduces your purchasing power over time by increasing the cost of goods and services. For example, if you paid ₹50 for 1 kg of sugar three years ago and now pay ₹120 for the same quantity, your money’s value has eroded significantly.

To maintain your purchasing power, your investments need to grow at a rate higher than inflation. If your portfolio grows at 2% annually but inflation rises by 3%, you’re effectively losing money.

Thus, real returns, also known as inflation-adjusted returns, give a clearer picture of your portfolio’s performance. If your investments are also subject to taxes, it’s crucial to consider post-tax returns—your returns after accounting for taxes.

How to Calculate Real Returns

Calculating real returns helps you evaluate your portfolio’s performance and make informed investment decisions.

Formula:
Real Return = Nominal Interest Rate (%) - Inflation Rate (%)

Alternatively, online real return calculators are available to simplify the process. However, it’s important to choose an appropriate inflation rate.

For example, if you’re saving to buy a house in 10 years, consider inflation forecasts by the RBI and economic trends. Assume a 6% inflation rate for calculations. If your real return projection is 10-12%, and inflation rises to 7-8%, your portfolio may underperform, leaving you short of funds to achieve your goal.

In extreme cases of high inflation, your real returns could shrink to single digits—or even turn negative.

Investing to Beat Inflation

To counter inflation, investors are often advised to choose asset classes that historically deliver inflation-beating returns or to invest for the long term (over a year).

While this advice is sound, finding a consistently inflation-beating asset class over 10-15 years is challenging. Let’s explore some options:

1. Equities: Historically, equities have outpaced inflation. For example, between 2015 and 2019, equity investments delivered average returns of 28%, while average inflation was 6%, resulting in a real return of 22%. However, after factoring in taxes, this figure declines.

   • Caution: Equities are inherently risky and volatile. In the event of a market correction or prolonged sell-off, returns can drop significantly, even during periods of low inflation.

2. Gold and Fixed Income Options: Diversified portfolios with investments in gold, fixed deposits, government schemes, and other debt instruments can offer stability.

3. Diversification: A well-diversified portfolio ensures that if one asset class underperforms or fails to beat inflation, your overall returns remain resilient.

Key Takeaways

• Real returns provide a true measure of your portfolio’s performance after accounting for inflation.

• Always factor in both inflation and taxes when assessing your investments.

• Diversify your portfolio to mitigate risks and improve your chances of achieving inflation-adjusted growth.

By understanding and planning for real returns, you can protect your investments from the eroding effects of inflation and stay on track to achieve your financial goals.