Why real return and NOT nominal rate decides your success in investing?   Sep 16, 2013


Most of Indian households prefer bank fixed deposits over other asset classes. By nature, they are conservative. As per data published by RBI, about 56% of total household savings are invested in bank fixed deposits and nearly 15% go in provident and pension funds. Proportion of equity assets in total household savings has been just about 3%. It is often said that equity markets are unpredictable and thus the fixed deposit has been a preferred investment avenue. However, in investments, what should really matter is real rate of return. Real rate of return is nothing but inflation adjusted rate of return.

Over last 3 years, inflation has stayed very high. Average inflation measured by the movement of Wholesale Price Index (WPI) has been 8.7%. Assuming interest rate offered by banks on fixed deposits at 9%, real rate of returns would be just 0.3% which is extremely low. On the other hand, returns generated by equity assets have also been very low. In other words, investors have not earned adequate risk adjusted returns over last 3 years with either equity or fixed income assets. Participation of Indian investors in equity markets has stayed low and mutual funds too have seen continuous redemption pressure.

PersonalFN believes that instead of focusing only on nominal rate of return, i.e. interest rates offered by banks or the gross returns generated by a diversified mutual fund; you should always concentrate on tax-adjusted real rate of returns.

Unpredictability of inflation
Annual Inflation
(Source: Ministry of Statistics and Programme Implementation, PersonalFN Research)

As depicted in the chart above, inflation was low in 2007-08 and 2009-10. These were the years when investors had earned positive risk adjusted real returns. Equity assets had done well in fiscals 2006-07, 2007-08 and 2009-2010. Due to relatively low inflation and higher nominal returns; the real rate of return was very high in equity assets. On the contrary, in 2008-09, 2010-11 and 2011-12 when inflation was high and nominal returns generated by equity assets were low or negative; fixed income instruments had done better in terms of generating higher risk-adjusted real rate of returns. Although inflation has started dipping in the current fiscal; there is still a huge upside risk due to depreciating rupee.

PersonalFN is of the view that, timing the market is extremely difficult and thus investors should avoid speculating over the market movement. There is an inverse relation between inflation and the real rate of return. Also, equity and debt as asset classes share inverse relationship. Those who believe equity assets should be avoided since they are volatile and risky; run a risk of generating lower risk adjusted real returns when inflation is low and return from equity assets is high. On the other hand, those who believe fixed income assets generate lower returns and thus should be avoided; run a risk of getting severe blows when equity assets perform badly and inflation is high. PersonalFN believes investment decisions should be guided by long term financial goals. Every asset class has its role in a personal financial plan. Therefore, PersonalFN is of the view that investors should take a holistic view of their financial circumstances and take a call on following right asset allocation.

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Jan 07, 2015

Clear, informative, simple. Could I send you some e-hugs?