Understanding Inflation-Adjusted Returns

In India, inflation has been breaching the Reserve Bank of India’s (RBI) tolerance level of 6% since January 2022. Similarly, retail inflation jumped to 7.4% in September from 7% in August due to a spike in food and energy costs.

Inflation tends to have an effect on investments as it reduces real returns if the returns are not adjusted against the surge in price. 

It is crucial for investors that instead of focusing only on the nominal rate of return (NMR), that is, interest rates offered by banks or the returns generated by mutual funds, they should always concentrate on the real rate of returns. 

Generally, the nominal rate of return is the actual rate of return earned on an investment before adjusting for any deductions and premiums, including investment fees, trading costs, tax expenses, and inflation.  

In investments, what should matter is the real rate of return. Simply put, inflation-adjusted returns are the real return an investor receives on an investment. It takes the nominal return of a security and deducts inflation, arriving at a real return. Comparing investment opportunities on an inflation-adjusted basis, particularly across borders, is critical to conclude real comparisons. 

It is important to understand that a positive nominal return can be negative in real terms in case inflation is higher than the nominal return.

Inflation is unavoidable and is known to eat into returns. A negative inflation-adjusted return is known to take a toll on the investment in the long run and investors need to remain wary of this.