If you get a return of 9%, and inflation is 5%, what is your real return?

You might think it's (return - inflation)
=> 9% - 5% = 4%

Well, that's actually just an estimate. Here is how you calculate the real, real return (for real!)

[THREAD]

Let's say you had R100.

And let's say that, coincidentally, a widget also costs exactly R100

Using some advanced Maths, you can work out that your money can buy you precisely 1 widget.

Now, let's say instead of buying a widget with your R100, you invested it and got a 9% return.
After 1 year, you will have R109

In that same year, inflation (at 5%) will mean the price of the widget is now R105

So that means you can now buy R109/R105 = 1.038 widgets

I.e. In widget terms (what your money can actually buy) you are 3.8% better off than a year ago

So your real return is 3.8%
(Not quite the estimate of 9% - 5% = 4%)

The correct way to calculate real returns is as follows

So what's the big deal, why does the difference matter?

Well, in low inflation, lower return environments like the US and Europe, it doesn't matter that much.

E.g. with returns of 5% and inflation at 1%
Estimated real return => 4%
Actual real return => 3.96%
No biggie

But in high inflation, high return environments (like the good old RS of A), the difference is bigger and can affect planning and projections (especially over the longer term)

E.g. with returns of 12%, inflation at 8%
Estimated Real Return=>4%
Actual Real Return=>3.7%