The Inflation-adjusted return measures the return that accounts for the inflation rate throughout the period. This statistic calculates the return on an investment after taking inflation into account.
When the inflation effects are removed from an investment's return, the investor can view the security's genuine earning potential without the influence of external economic forces. The actual rate of return is also known as the inflation-adjusted return.
Inflation-Adjusted Return = ((1+ return) / (1 + inflation rate)) - 1
There are three fundamental processes to calculating the inflation-adjusted return. The Return on Investment must first be calculated. Second, the period's inflation must be estimated. Third, the amount of inflation must be geometrically deducted from the investment's return.
Consider the case of a bond investment that earned 2% the previous year. It appears to be a positive outcome. Assume, however, that inflation was 2.5% last year. It means that the investment failed to keep pace with inflation, and it lost 0.5% of its value.
Assume that the stock returned 12% last year and that inflation was 3%. An estimate of the real return rate is 9%, equal to the reported return of 12% minus inflation.
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Using inflation-adjusted return is often a good idea because it puts investment opportunities into a real-world perspective. Having a focus on how investments are doing over the long-term can present a better picture of its past performance.
There are some good reasons why nominal returns work over inflation-adjusted ones. Nominal returns get generated before any investment fees, Taxes, or inflation. Since there is a here and now world, these nominal prices and returns are what one has to deal with immediately to move forward. So, most people will want to know how an investment's high and low price is—relative to its prospects—rather than its past performance. In short, how the price fared when adjusted for inflation five years ago won't necessarily matter when an investor buys it tomorrow.
Since each country's inflation rate is factored into the return, the inflation-adjusted return helps evaluate investments, especially between countries. In this scenario, an investor's outcomes, when examining an investment's performance, could be drastically different without controlling for inflation across international borders. Compared to other investments, the inflation-adjusted return is a more accurate estimate of an investment's return.