The Inflation-Adjusted return explained.
The Inflation Adjusted Return, also known as the Real Rate of Return, is the Return on Investment after accounting for inflation. Inflation refers to purchasing power of money decreasing due to a general increase in the prices of goods and services. The inflation-adjusted return is a precise measure of the true value of the return.
Some investors and fund managers focus more on the IAR ratio than others. It’s a matter of personal preference whether investors measure their performance considering inflation. There are mixed reactions to the fears of inflation, but I don’t pay too much attention to it. I am not saying it isn’t important, but I am focused on finding the best compounders over decades. By following a rigorous strategy and Investment Process, I can continue to find those companies that will outpace inflation.
If inflation risk is a concern, then design your investment decisions around finding opportunities that can help you beat it. Understanding purchasing power and preserving it can help you analyse investments from a different perspective. When it comes to asset allocation and Portfolio Management, focus on the best ideas that will outpace inflation to provide the best returns.
Finding long-term quality compounders that have a CAGR of 12-15% and holding them will go a lot further than finding poor quality ideas that compound at 2-4%.
The IAR can help with retirement planning to ensure that you have enough income to combat the rise of inflation. I believe a well-diversified portfolio, not just in public equities, can help. Real Estate often rises during inflationary times, and dividend-producing stocks can help bring in more income.
What is the inflation-adjusted return formula?
- Inflation Adjusted Return = 1 + Investment Return Γ· 1 + Inflation Rate – 1 x 100
Investment Return (Nominal Return) The nominal rate is the rate of return on an investment, such as the increase in capital in an investment, a bond return or a fixed deposit account. Below is the calculation of the Nominal Return.
For example if we started with $100,000 as the Beginning Value and the Ending Value was $109,750 it would look like this.
$109,750 – $100,000 Γ· $100,000 x 100 = 9.75%
Inflation Rate is usually the Consumer Price Index (CPI) which tracks the average change in price across time of consumer goods and services. You can find this info on Government or market data sites and should be used for where you are domiciled.
How to use the IAR?
Let’s use a simple example of two investment portfolios over a 1-year period rather than looking at a singular position or investment. Assuming one investment portfolio is designed to focus on finding the best ideas long-term to combat inflation. The second portfolio is not structured well and has a sub-par investment strategy.
| Investment Portfolio | Portfolio A | Portfolio B |
|---|---|---|
| Starting Capital | $1.5 million | $1.33 million |
| Ending Capital | $1.66 million | $1.39 million |
| Nominal Return | 10.66% | 4.51% |
| Inflation Rate % | 3.5% | 3.5% |
| Inflation-Adjusted % | 6.91% | 0.97% |
Portfolio A (1+0.1066) Γ· (1+0.035) – 1 x 100 = 6.91
Portfolio B (1+0.0451) Γ· (1+0.035) – 1 x 100 = 0.97
If we look at these portfolios considering the inflation adjustment, then it creates a very different picture of returns. Portfolio B may seem fine to the investor showing a 4.51% nominal return however after inflation it is not even 1%. Purchasing power will erode 0.97% even further over time.
Portfolio B boasts an after-inflation return of 6.91% and would be considered reasonable to long-term investors. The difference between the two portfolios over a year may not raise concern but the difference in return from Portfolio A to Portfolio B is 6%. Compound that over a decade or two and that is some real inflation-beating returns.
In Summary…
Investors can use Inflation-Adjusted Returns to compare different investment opportunities by taking into account the impact of inflation on their potential returns.
Nominal returns alone do not provide a reliable picture of an investment’s true value. By using IAR, investors can better understand their portfolio’s performance and determine whether their investment style is paying off.
An investor can make adjustments to an investment strategy and process to ensure that long-term effort, risk, and patience is rewarded with inflation-beating returns on capital.
I believe the best way to combat inflation is by finding high-quality growth stocks and holding onto them.
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