A real rate of return is equal to the actual amount an investor makes on a given investment. When a person invests money, he does so to get a return. The return is normally expressed as a percentage of how much he made. Simply taking that percentage given at face value, however, can result in an improper calculation of how much was actually earned on a given investment.
People invest money to see that money grow. Common sources of investment are stocks, bonds, mutual funds, certificates of deposits, money market accounts and savings accounts. When an individuals buys one of these, or another investment product, he does so because he wants to earn money on the money he puts in. In other words, he wants his money to make money — or to create a return on his investment.
The higher the return on an investment, generally, the better that investment is. While other factors go into a calculation of a good investment, such as the riskiness of the investment, the rate of the return is one of the most important. Therefore, it is essential for investors to be able to understand and calculate the real rate of return. This is especially true since few investments report this number, so investors have to calculate it themselves.
The real rate of return refers to the amount made on the given investment after adjusting for other factors, such as inflation or other external factors, that alter the value of money. Assume, for example, that an individual invests in a money market account promising a three percent rate of return. In reality, however, if inflation is three percent, then that investor's real rate of return or actual earnings on his money is equal to zero. As such, the investment is not nearly as attractive an investment as it seems, and the investor will not be growing his money at all.
Understanding the real rate of return thus means understanding what inflation is and adjusting for it. Inflation refers to the declining value of a given currency. For example, $1 US Dollar (USD) today may not be worth $1 USD tomorrow, if tomorrow the price of goods has gone up. If an ice cream today costs $1 USD and an ice cream tomorrow costs $1.10 USD, then the dollar a person had is no longer worth as much, relative to what he can buy.
Therefore, if an investor wants to know how much his actual purchasing power has grown, he must adjust for inflation. If there are any other external factors, such as a declining value of currency, then this should also be adjusted for as well. Only by subtracting the affect of these outside factors can a person know how his money is actually doing.