Usually when someone is talking about how well an investment has performed – they are usually talking about the actual percentage increase of the value of that investment over a certain period of time. For example if an investor bought a mutual fund at the beginning of the year for $100 per unit and sold it at the end of the year for $107 per unit, they might say that they “made a 7% return” on their investment.
A 7% investment return is pretty decent – at that rate the original investment will double in 10 years. This sounds great – all you have to do is save your money, get a reasonable rate of return and eventually you will a lot more money then you started with. The only problem is – what happens if the things you like and need to spend money on go up by 7% as well? In terms of your purchasing power – after 10 years, it will be no greater than when you made your original investment.
On the other hand what if the costs of items you like to buy didn’t go up at all? In that case, after 10 years you would be able to buy twice as much stuff as when you made your first investment.
Use real return for investment planning
The real return of an investment is defined as the total return minus inflation rate. This can also be thought of as the “net return”.
Let’s say your portfolio has gone up at a rate of 6% per year for 20 years. This is the total return. Over that same time period, inflation was 2%. To get the real return, we subtract 2% from 6% and get a real return of 4%.
Using the real return is the best way to measure your long term investment performance because shows the actual increase in purchasing power.