Real return vs. Nominal return

Great number of people do understand that a savings or fixed deposit (FD)account in local financial institution generates a decent return for money kept for a duration of times.Mostly are satisfied with the return, albeit is a small quantum. However, people are getting more and more investment savvy;thanks to the vast pool of knowledge the electronic mass media and the much prevailing of information flow that is reaching our population.People are more knowledgeable these days in comparison to a decade ago.
Going back to the subject of 'return' from savings or FD, the return is a nominal type and therefore does not reflect the real gain/loss in value which the money in relation carries throughout the holding period. To illustriate;

Example:
A RM 10,000 deposited in a FD account that gives you a return of 3.70% per annum will generate RM370/- as interest at the end of first year(assuming the money is kept for a year).
After the first year, your total money received will be the sum of principal (RM 10000/-) and RM 370/- (the interest gain)which will sum up to RM 10370/-.

Now, ironically, this return reflects a misleading picture as far as real return is concerned.

Why? It is because that RM 10370/- does not take into consideration of the inflation rate factor. Ignoring the effect of inflation will to a greatest extend prompt you to make unwise financial related decisions. The risk of inflation is a determining element in achieving real returns! So, how do we incorporate the inflation rate into the FD return as in the example above?

Do assume that all data in the example above remains the same. In this context assume that there is an inflation rate of 2.0% on the back of the 3.70% FD rate. In continuation, the Inflation-Adjusted-Interest rate is now hereby computed as :

(r-i) / (1 +i)power of n

Where r is the FD return per annum
i is the inflation rate given.
n is the number of years of the holding period.

Now, after substituting the data in the example above into the formula given, you will get a figure of 1.67% as the inflation-adjusted-interest rate.

Next step is, to replace the 3.7% with 1.67% and then do the simple calculation again as shown in example above to find the interest rate gain after the end of holding period. You will get RM 167/- as the answer.

CAN YOU NOTICE THE PLUNGE IN THE GAINED VALUE ?

This type of return is called the REAL RETURN of the saving's instrument.

Here's one more example for you :

Again, assume all data in this example remains same as in the example above, except the interest rate.
Principal = RM10000/-
FD Rate = 3.7%
Holding period = 1 year
As for the inflation rate, take 5% as this is more accurately reflects current Malaysia's CPI Index.

Can you compute the real return?

You will get RM 9876/- and this is a loss making investment.

This simply means that it is always not a good decision to keep in a savings instrument that bears an interest rate lower than the prevailing inflation rate!!
ALWAYS CHOOSE A PRODUCT THAT GENERATES INTEREST RATE FAR MORE THAN THE INFLATION RATE.
HAPPY SAVINGS!!