Real Rate of Return - Real Wealth Creation

We as investors are mostly interested to know what returns I am going to get from my investments. It is seldom asked what is the real rate of return I am going to get.

It is very important to understand the real rate of return that is expected to come from one's investment rather than the absolute return which generally an investor ask for. To understand what you actually mean by the real rate of return and how it really helps in Wealth Creation you need to spare a few minutes to read through the article.

What is Real Rate of Return?

In simple terms, it is the return you earn above the inflation rate – which is the rate at which the prices, in general, are rising. To exemplify, if you invest in a fixed deposit which is today giving you a return of say 8% and the inflation is 6% then the real rate of return that you are generating would be 2%, ie., actual return (less) inflation for the period. The logic is simple – Rs.100 one or say 10 years ago does not carry the same value today because things have become costly due to inflation. Generally, consumer price Index growth (CPI) or wholesale price index growth (WPI) is taken as inflation indicators.

Having understood whats the real rate of return is, the question is how it is related to wealth creation. Let's understand what actually wealth creation means. Putting jargons aside wealth creation in simple terms is the increase in one's ability to purchase more things. If one feels his ability to purchase things have increased substantially over a period of time, one can simply say he has created wealth.

How can one increase its ability to purchase more through prudently investing?

That's a very right question to be answered. Let's go back to our example of one investing into fixed deposit with 8% absolute return and 2% real rate of Return. Say the investor had Rs 1,000 to invest in a fixed deposit. At 8% of interest rate, the value after one year of the amount invested would be Rs.1,080. Now assume that with Rs.1,000 he could have bought 50 packets of milk priced at Rs.20. Now with 6% inflation (assumed price increase of milk), the price of milk packet would be Rs 21.3 after one year.

At Rs 1080 available with the investor from his investment he now would be able to buy 51 packets of milk. The purchasing power of the investor has increased by one packet of milk thanks to the positive real rate of return. Had his return on investment been equal to the inflation he would still be able to buy only 50 packets of milk. And had his investment return lesser than the inflation, negative real rate, his capacity to buy milk packets would get reduced. That is the explanation why for creating wealth it is important to look at the real rate of returns and not the absolute returns on your investment.

Now interestingly let us look at the table below highlighting the approximate real rate of return across different asset class in India from 1981 – 2019. The question to ask is how it has increased the purchasing power similar to our example above over the period?

(Source: NJ Wealth – Internal. Assuming average inflation during period @ 6%.)

The results mesmerize us as to how the real rate of returns in equities over the period has increased the purchasing power and hence created wealth.

Never in the period considered had equities ever had a linear growth. There were many periods or phases when everyone considered to be the worst time for equity investors. For example, the equity markets in India post Harshad Mehta Scam (1994- 98) or post the Y2K technology bubble (1999-2001) or the after the Lehman brothers (2008-2012) and many such periods of dullness. But over the longer period, equities still delivered a real rate of return which increased the purchasing power the most as illustrated in the table.

Does the real rate of return increase the purchasing power over the shorter period say 5 Years?

The answer is NO. For a change in purchasing power, we require both time and returns.

What if we assume the same returns for the investor as return generated over 38 years to be generated in 5 years and measure the impact on the purchasing power?

There will be very marginal difference in the results and one cannot distinguish one from the other. Also, since equities are volatile in short-term, we cannot expect the same results of long term in the short term. That is not the nature of equities and something that everyone should understand.

Conclusion:

Equities change the purchasing power to a great extent and it been the biggest wealth creator across all asset class over a longer period, 10 years at least but longer the better, with the short term volatility. I would never understand why investor invests in equities and start seeing returns on a day to day basis and gets disturbed with short term negative returns. It is important to have a firm long term belief and give time to your equity investments for Real Wealth Creation through Real Rate of Returns from Equity Investments.