BackDo you know the real return on your investments?
Real returns can be very far from what the product shows, mostly due to inflation
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What you think you will get and what you get really are two vastly different numbers—be it examination results, the month’s salary or returns on investments. If it’s a big shock to receive 80,000 as salary when you had thought you will get 90,000, imagine how miserable you will feel when the in-hand amount from a matured fixed deposit gets reduced due to inflation and taxes. The gap between perception and reality is due to not understanding real returns. And this is a problem across the globe because investors only look at the numbers that investment products show.
Real returns can be very far from what the product shows, mostly due to inflation. Here’s how you can calculate the real returns on your investments and avoid unnecessary shocks in the future.
What is real return?
Real return is the actual benefit that you get after accounting inflation. If you are invested in a product that attracts tax, your return reduces even further. Surya Bhatia, a Delhi-based financial planner, said, “While investing in any asset class and looking at its returns, always factor in inflation. In the past two-three years, inflation based on Consumer Price Inflation Index (CPI) has been hovering at 8-10% levels. Hence, you should look at products that have the potential to give returns higher that the inflation rate."
Simply put, inflation is an increase in price over a period of time which basically reduces your purchasing power. Say, a product costs 100 today. At an inflation rate of 8%, it will cost 108 next year. For this reason, your investments should at least be able to keep pace with inflation.
A component that is more visible and immediate than inflation is taxes. All financial products have either taxes or charges attached.
The best case scenario is when real returns are positive. If it’s negative, it means your savings and investments are shrinking instead of growing.
Let’s look at some of the popular products to understand how real return is calculated and its effect.
Fixed deposits
FDs are considered one of the most popular financial instruments in the country. Whenever you plan to park money in an FD, the first thing you check is the interest rate. At present, FD rates are in the range of 8.50-9.25%. What we forget is that bank deposits attract taxes.
For an individual falling in the 30.9% tax bracket, 8.50% annual return from an FD would get reduced to a net return of 5.87%.
The formula to use: rate of return * (1-tax rate). So, in our example, it would be: 8.5% * (1-30.9%). Then multiply this number by 100.
If you are in the 20.6% tax bracket, your net return will be 6.75%. For those in the 10.3% tax bracket, the net return will be 7.62%.
Now, let’s factor in inflation of, say, 8%. In this case, a post-tax return of 5.87% for individuals in the highest tax bracket will translate to a negative figure of -2.13% (5.87%-8%). If you are in the lowest tax bracket, you will get a return -0.38% (7.62%-8%).
What these numbers indicate is that most FDs will give you negative real returns.
Small savings instruments
Another favourite is Public Provident Fund (PPF), which enjoys the exempt- exempt- exempt or EEE status in tax treatment. In other words, the contribution, accumulation and withdrawal are all exempt from tax. So, assuming long-term inflation to be 8%, the real rate of return from PPF that gives a return of 8.7% will be 0.7%. This shows that PPF, a risk-free and tax-free investment product, is capable of generating positive returns or real returns after accounting for inflation.
Mutual funds
For the sake of illustration we will look at Mint50, Mint’s curated list of 50 mutual funds (MF). We took three categories of schemes: large-cap, large- and mid-cap and short-term debt funds from this list. As on 22 April, large-cap funds category average 5-year return was 16.26%. Large- and mid-cap funds’ 5-year category average return touched 17.58%, while one-year return of short-term debt funds was 7.63%.
For equity funds, the long-term capital gains (LTCG), tax is nil. If we assume five-year inflation at 8%, in case of large-cap funds, you would have got a real return of 8.26%. For large- and mid-cap fund, the real return would be 9.58%.
In the case of debt funds, LTCG tax is 10% without indexation and 20% with indexation benefit. Indexation means adjusting the price for inflation. Every year, the government declares a cost inflation index, which is then used to calculate the indexation.
Therefore, for short-term debt funds after considering indexation, the real return would be –0.37%.
Srikanth Meenakshi, director and chief operating officer, FundsIndia.com, said, “MF are best positioned for providing positive post-tax real returns over the long run due to beneficial tax rules as well as exposure to high potential growth assets such as equity. Investors should always look for potential to generate positive real returns when considering investment choices."
Best choice
As interest is taxed at the highest marginal rate for FDs, it would make more sense to look for investment instruments that at least have tax benefit.
So, the next time you want to invest, rather than looking merely at the returns advertised, sit with your calculator and figure out the real return first. You can find real return calculator on the Internet. After all, you want to make money, not lose it.
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