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By Christian Charest | 11-15-2018

The Morningstar Dictionary: Real returns

When looking at returns in the context of what investments will be worth over time, it's essential to consider inflation.

Christian Charest: When we look at investment returns posted by fund companies or on third-party sites like Morningstar, what we're seeing reflects the increase in the investment's price and, in the case of total returns, the effects of income distributions on the investment's value. What those numbers don't tell us, however, is how much purchasing power those returns will provide to their investors.

That's because inflation always takes a bite out of your returns, though the size of that bite can vary. Because of inflation, goods and services will cost more in the future than they do today. For example, assuming a rate of inflation of 2.5%, which is roughly what the Bank of Canada expects in the near future, something that costs $1,000 today will likely cost more than $1,600 in 20 years.

So when you're making financial projections to determine how much you'll be able to spend in the future, or assessing the increase in wealth that investments have provided in the past, you need to account for inflation, and the way to do that is to calculate inflation-adjusted returns, or what are called real returns. The formula is pretty easy: you start with the nominal rate of return -- that is the advertised rate of return -- and subtract the rate of inflation, as measured by the Consumer Price Index.

Real returns need to be positive in order for investments to provide a real increase in wealth. That's why over the long term, ultra-safe investments like Treasury bills or GICs are likely to reduce your wealth, even though the actual dollar value will increase. If a GIC pays 1.5% interest, that's not enough to cover the 2.5% inflation, and your real return is negative 1%, meaning that your money's purchasing power will decrease year after year. Even longer-term government bonds have a hard time keeping up with inflation, so for long-term goals such as retirement, it's essential to include a good dose of stocks in your portfolio, even though they come with higher risk.

For Morningstar, I'm Christian Charest.