Real Return Details

If an investor purchases a bond that will yield five percent in a year and the inflation rate for that year is three percent, the real return on his investment is two percent. A negative real return occurs when the inflation rate is higher than the yield. In this case, the investment is effectively losing money.

Inflation has two leading causes. Firstly, when demand for goods or services is higher than the supply can meet. Because goods or services are relatively scarce, the supplier raises the price. Secondly, a supplier's costs increase; for example, there might be a scarcity of raw materials or a demand for an increase in wages. A modest inflation rate can benefit an economy as consumers spend more to avoid future price rises. However, inflation is not good for investors who have placed their money in bonds or other investment vehicles which offer a fixed return. In this case, every percentage rise in inflation represents an equivalent percentage fall in the yield which the investment offers.

As the main objective of investors is to guarantee a reasonable return on their money, inflation is a factor that they must take into account.

Real Return Example

Dimitri is a very cautious investor trying to ensure a comfortable retirement; he has generally bought into steady and safe investment products such as government bonds. However, yields on government bonds are very low, which entails such a low return on his money that his investments are vulnerable to inflation. Partly because government bonds offer a low return, investment money has flowed into shares which means that the stock market is very volatile.

Dimitri comes to the conclusion that he has only two alternatives. He can assume extra risk in an attempt to receive the same return, or he can settle for a lower yield. There are real return funds available that aim to give investors a certain level of certainty that they will achieve a specific yield while avoiding unnecessary risk. Real return funds tend to invest in a wide range of assets to cut the risk to a minimum. It might be a good investment for someone in Dimitri's situation.

Types of Real Return

The website investopedia.com identifies nine top assets which protect against inflation. The level of risk for each of them differs. They include the following:

  • Gold
  • Commodities
  • 60/40 Stock/Bond Portfolio—spreads risk and generally considered to be safe
  • Real Estate Investment Trusts—as property prices and rents tend to rise with inflation, these investments should always offer a positive real return
  • Standard and Poor's 500 Index—historically outperforms inflation
  • Real Estate Income—entails renting out properties and allows an investor to adjust the rental charged in line with inflation
  • Bloomberg Barclays Aggregate Bond Index—broad based
  • Leveraged Loans—can be risky as they are generally offered to people or institutions with a poor credit rating.
  • Treasury Inflation-Protected Securities

Investment always carries a risk, so it is never certain that an investor can guarantee a positive real return. In general, the best advice would seem to be to have as comprehensive a portfolio as possible.