What are REAL Returns?

In the previous article, we sought to explore if there is any magical number to measure good return. And yes, that magical number is based on your real return. To understand real returns, it would be good to begin understanding inflation. There are two types of inflation, wholesale and retail. The retail inflation (a.k.a CPI) measures the price rise of a common basket of 460 commodities primarily used by indian households. Wholsesale inflation is used for national GDP accounting, while retail inflation is adopted by RBI for determining interest rates in the country. It also forms the basis for wage rise.

Inflation-adjusted Income to meet Cost of Living

Senthil, a professional is 43 years of age. Let us say 20 years ago, in 1998, Senthil earned Rs.8000/- and at that time, his family’s expenses were about Rs.5000/- p.m. At an average wage rise of 12% p.a and an inflation rate of 6.5% p.a, today his income rises to Rs.77k p.m and basic expenses rises to Rs.17k. However, due to higher spending on lifestyle expenses such as consumer goods, gadgets and travel, his present monthly expenses have risen to Rs.50k p.m.

If his income was not adjusted to the rate of inflation, he could not afford his daily basket of goods. This is why it is important that wages be adjusted to inflation annually. On the other hand, it is important to note here that his savings rate has remained the same, at an average of 33% through out the 20 years.

What are nominal & real returns?

We invest today to get a certain return in future. As inflation keeps rising year-over-year, we would like our returns to be higher than the inflation, so that we could afford to buy the same basket of goods & services in future, with the returns from investments made today. Investment returns stated plainly are called nominal returns (7%). When nominal returns are adjusted by inflation rate (6.5%), we get real returns 0.5% (7% - 6.5%).

Why Real Returns matter?

A higher real return is important to make your retirement worry-free. It also determines whether you could retire early or you have will sufficient corpus to sail through your retirement life.

Senthil has 15 more years to retire. If Senthil had used only fixed income instruments like fixed deposits, despite saving 33% of his salary, he would have accumulated only Rs.44L at the end of 20 years. His Rs.44L corpus could provide him with only the basic cost of living expenses of Rs.17k, during his retirement. He would not be able to afford the additional lifestyle expenses (gadgets & travel) with his savings, even if he works for the next 15 years. This is because in the case of saving via FDs, real returns are only 0.5% = 7% FD – 6.5% inflation rate.

Fortunately, Senthil had invested a good part of his savings in market-linked products, which have accumulated to Rs.62Lacs in 20 years, 40% more than the FD route, so not only he could comfortably afford his current lifestyle of Rs.50k at the time he retires, he could also retire 5 years early, if he wishes to. This is because real returns from his market-linked portfolio is higher at 4% = 10.5% Portfolio returns – 6.5% inflation rate.

Why only 10%, couldn’t Senthil get a 20% return on his portfolio?

If Senthil owns a 1000 sq.ft house that he bought 10 years ago for Rs.20L and he expects a return of 20% p.a on it today, he needs a buyer to pay him at least Rs.1.2Cr for his property. Would you be Senthil’s buyer? Most of us would not be willing to pay this price especially when similar sized units are available at a much lower price in the market, at Rs.75L, which translates to a 14% rate of return for Senthil.

As a seller, it would be unreasonable on Senthil’s part to expect a buyer to pay a price that he himself would not pay for a similar property. And this return is from only one asset in Senthil’s portfolio. The combined returns of his entire portfolio would be lower due to varied returns of different asset types. Return on investment also depends on the economic state of a nation. If a nation’s GDP grows at 8% p.a, it is only reasonable to expect a nominal return of 12% p.a = 8% GDP + 4% real return.

How could I attain a realistic real return of 4% consistently?

Saving via bank FD or other fixed income instruments alone is not sufficient to attain a real return of 4%. It is also important to not be overweight on gold or property as they are not liquid assets. Investing a certain portion of your assets in market-linked products would enhance your real returns from 0.5% to 4% in the long term and help to meet your retirement income needs. In order to build a right asset mix, we need to understand the various assets, their inherent risks & the nature of their returns. We shall continue in the next session..