Real returns from any investment that shows a marked difference from the nominal or investment return guaranteed from the investment instrument is mainly on account of inflation and the other aspect of tax. And, investment is supposed to be lucrative and efficient only when returns from it is able to beat the current level of inflation.
As only then it shall be able to fetch you money to cope up with the ongoing increase in rate of inflation and make the whole purpose of investment for realizing substantial returns meaningful. So, real return is nothing but the return realized after accounting for inflation. Nonetheless, implication of tax on the investment further lowers the return.
Positive real return signifies growth in the savings and investment while negative real return relates to lowering or shrinking of the investment as against its growth which is not good for the investor. The emphasis on positive real return makes sense as otherwise it lowers purchasing power of money.
Different investments fetch either positive or negative real return; and investor shall be better off in estimating this level in advance.
Small savings scheme including PPF that attracts no tax either on the contribution, accumulation or redemption and provides a return of 8.7% for the financial year is able to provide a positive real return if considering the long term rate of inflation to be 8% it assures a 0.7% real rate of return on the PPF investment.
Another investment that is indeed popular with most of the investors and more so with the conservative or risk-averse investor class that fails to provide positive real return is bank fixed deposits. As bank fixed deposits other than some 5-years tax saving fixed deposits attract tax liability.
So, a person falling in the higher tax category, will lower his net return from the investment due to taxation and when such return shall be adjusted for inflation, investors shall not be able to realize positive real return.
At present, bank FDs on an average fetch 8-9.5% return, and for an investor falling in the highest tax bracket of 30.9%, his post-tax return can be computed using the formula:
Post-tax return from investment- Rate of return(1- rate of taxation) * 100
So, when the interest rate per annum from an investment is 8.5%; post-tax return will come to be 5.87% which shall not be able to beat the rate of inflation of 8% and hence fetch negative real return.
Mutual funds on the other hand that are being constantly promoted as an investment option with equity exposure as well as tax benefits, has more of scope to provide real positive returns.
Over the long-run, equity funds do not attract long-term capital gain and an average return of say 15% on large-cap fund when accounted for inflation provides positive return. Debt funds on the other hand that attracts LTCG of 10% without indexation and 20% with indexation shall offer negative real rate of return.
Returns from an investment in equity should be computed after accounting for corporate dividends, bonus etc together with other expenses which an investor incurs either as brokerage or other charges. Suppose, a share earns you bonus shares, then cost price of the share has to be adjusted for the bonus.
For instance in case the cum bonus cost price happens to be Rs. 100 and you realize bonus in the ratio of 1:1, then cost price after bonus will be Rs. 50. And, sale of stock for Rs. 60 will provide an absolute return of 20%.
So, in order to realize returns that are able to beat inflation rate, investors should necessarily consider investment in instruments that are tax-efficient as well as come with tax-benefits and hence are able to offer your positive real return. Investment portfolio of the investor should hence be a mix of stocks, mutual funds and tax-free bonds.