Thumb Rule for Real Return Calculation

There are several parameters we check while we make any investment. We usually check whether product gives us tax benefits or not and how liquid it is should we need to liquidate it during need of money. There are several other such parameters on which we evaluate investment product but as far as Indian concerned, I believe, all such parameters takes back seat and prime parameter we consider for choosing any investment product is how much returns does it give and how risky it is probably second most parameter we enquire about. I am sure that they are the prime questions we usually ask when we ask anyone about any investment product.

It’s relatively easy to answer the second question, how risky it is. Usually, people have a perception that anything which is related to Stock Market is risky, and anything which is having assured return is a safe investment. In short term view it’s agreeable, but on long term view Stock Market related product gives sustainable and high returns as you can see on Google chart yourself on “max” tab, it’s on upward trajectory except for recession times, and explained in my earlier post as well. And, RBI gives assurance of 1 lakh only in case deposit taker (read Bank) goes bankrupt, read RBI link here on Q3, so assured return guarantee is only if deposit taker does not go bankrupt. It’s essential to choose investment based on product’s risk being within range of our risk tolerance and matches our liquidity requirements.

Now, Let’s tackle prime question which we usually ask, how much returns does it give. Usually, our mental model of returns is programmed to calculate returns is very simple which gets exploited by ads and salesmen (read agents). Buy Price — Sell Price = Profit or Loss. That’s the on paper calculation, in reality, we are expected to pay transaction charges and taxes which is ignored by our mental model of calculation. And another mistake is, above calculation is just simple returns we do not calculate annual returns in several transactions. And, Inflation is ignored totally.

So, here I propose a Thumb Rule I have developed for myself for calculating the real return. It help me uncover underperforming investment product, which my mental model ignores at most time. Below calculation is not perfect for calculating Annual Returns but easier enough to change above mental model calculation.

Real Return % = {([Return or Interest Amount — Transaction Charges — Taxes]/Investment Amount) — Inflation %}/Number of Years of Investment

If Real Return calculation gives negative value then it’s not desired investment product for me unless product’s liquidity is the priority. Bigger the Real Return value is better the product, assuming product’s risk category is in my acceptable risk tolerance and risk capacity levels.

For any investment product which has moving return numbers, stocks for example, then I prefer to take last five years average return as in most cases five years covers the full economy cycle of ups and downs. Similarly, For Inflation, I take an average of last five years numbers, accessible via easy Google query.

For Taxes refer here, Taxes Structure compiled by Santosh Sharma from Mint.

Take your current investments to this formula and see how it performs. I am sure above formula will help you uncover underperforming assets if any.

Enjoy.