Real Rate of return on your investment

Looking back over your portfolio it can be a little tricky to know how well or how badly you have actually done. I know, initially the task seems pretty simple, just look at how much it has grown and what interest rate that would be equal to. Sadly that is not your real rate of return. When we look at returns over time a very important factor is inflation. The money you have now, many years after you've made your investment, is worth quite a bit less than the money you initially invested.

A dollar now can't buy what a dollar could back then. So even if your portfolio shows that it has grown ten per cent over the past year, that does not in any way mean that you could use your money to buy ten per cent more goods or services than you could have at the beginning of the year.

Consumer Price Index

The consumer price index (CPI) is a measurement which shows inflation. The CPI takes a standard set of goods (milk, bread, etc) and determines the cost of that set of goods, it then compares that cost to the cost of the same set of goods in different time periods. So basically you could buy all of your groceries for $100 (Dh367) last year. Now those same groceries cost you $105. This $5 growth in price shows us that over that year there has been five per cent inflation (I used $100 to keep the calculations simple).

Now if we look at the above two examples; your money has seen a 10 per cent return, and the CPI has shown a five per cent inflation rate, then we can see that the difference in those is your real rate of return. In this case that real rate of return would be five per cent. If your portfolio had only grown four per cent you may still look at it and think it's OK since it still grew. In fact the money you have now would actually be able to buy fewer products because the products now cost five per cent more. In this scenario your real rate of return would be -one per cent, a loss.

Put in very simple terms your real interest rate is just the interest rate you earned minus the rate at which you lost purchasing power because of inflation. Looking at this rule you should be much better able to determine your actual performance in the market and dump securities that are under performing before it's too late. Looking at things too simply makes you miss the big picture and can cost you a lot of purchasing power in the long run.