What are Real Returns? Investing Explained

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In this series, we bust the jargon and explain a popular investing term or theme. Here it’s Real Returns. 

What do you mean? 

The amount that you earn from an investment after inflation is taken into account. 

To calculate the real return from a savings account, say, you would subtract the current rate of inflation from the ‘nominal’ or advertised rate. 

At present, the average rate on an instant access bank or building society account is 0.30 per cent. 

Subtract inflation – which, as we learnt this week, has gone up to 7 per cent – and the real return is minus 6.7 per cent, which means that you are losing a considerable amount of money. No wonder inflation is dubbed the ‘invisible thief’ of savings. 

Ups and downs: To calculate the real return from a savings account, say, you would subtract the current rate of inflation from the ‘nominal’ or advertised rate

Do shares provide a real return? 

Since 1908, shares have tended to outperform cash in this respect, but not in every case. The theory is the extra risk of investing in the stock market should provide a greater reward. 

Between 2008-2018, shares gave a real return of 5.8 per cent, against minus 2.5 per cent for cash, according to figures from broker AJ Bell. 

But, in the previous decade, the real return from cash was 2.4 per cent while that from shares was minus 1.5 per cent. 

The total return from a share is made of the capital gain, plus dividends and other distributions. if you bought a share a year ago and its value has increased by 4 per cent and it has also paid a dividend of 3 per cent, the total return would be 7 per cent. 

And the return from the FTSE100? 

The total return on this index over the past 12 months is 13.77 per cent. in the year to date it is 2.5 per cent, according to Bloomberg. 

AJ Bell forecasts that FTSE 100 companies will pay out £81.2billion in dividends this year and a further £32.7billion in share buybacks, equating to a yield of 3.7 per cent – which should make this the second-best ever year for cash returns from this index. 

It is tricky to predict, however, how the prices of the individual companies will perform amid the current economic and geopolitical uncertainty. Also, dividends can be cancelled or postponed. As a result, it is too early to say whether the index will provide a positive real return. 

How far could inflation rise? 

The current rate of inflation is the highest since March 1992 and it is likely it could increase further, reaching double-digits, as a result of pressure from rising energy, food and other costs and the war in Ukraine. 

In an attempt to tame the surging cost of living, the Bank of England is now predicted to raise the base rate yet again next month from its current 0.75 per cent to 1 per cent. 

But there is no guarantee that this strategy will prove effective. 

What does all this signify for investors? 

Sadly, it seems investors will need to lower their expectations. it also means that anyone saving for a rainy day or a comfortable retirement may now be obliged to put more money aside. 

This will be tricky for many, given the squeeze on income from higher inflation. The risk of leaving substantial savings in cash has also been heightened.