30 years: Financial markets trader

Chances are when someone quotes a figure for investment returns it’s likely to be on a nominal or gross basis, without taking into account the effects of inflation. Purchasing power only increases if returns outstrip inflation over a given period. Abdulla addresses this fact and explains how to measure real returns for a single period, and over time, to help us understand inflation-adjusted returns.

Chances are when someone quotes a figure for investment returns it’s likely to be on a nominal or gross basis, without taking into account the effects of inflation. Purchasing power only increases if returns outstrip inflation over a given period. Abdulla addresses this fact and explains how to measure real returns for a single period, and over time, to help us understand inflation-adjusted returns.

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4 mins 42 secs

Overview

Real returns are in other words, inflation adjusted returns. Over the long-term, it’s important to consider the impact of inflation on returns to determine if we are wealthier. We increase our purchasing power or wealth, if our returns outstrip inflation over a given period.

Key learning objectives:

Identify the two methods in calculating real returns

Use the calculation to determine if wealth has increased or decreased

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Summary#### What are the two methods of calculating real returns?

#### Real returns impact which parties?

Real returns are good for savers and investors. However, if you’re a borrower, you would prefer negative real rates, because it means you’re paying back devalued money.
####
Using the information in the table, how do we calculate the inflation index, inflation rate, fisher, real rates and investment?

#### Have we increased our wealth over this 5-year period?

- Fisher Effect Equation: Nominal rate - Inflation Rate. However, this disregards the effect of time
- Real Rate = (1+ Nominal rate) / (1+ Inflation rate) - 1

Years | Inflation Index | Nominal Rates/Returns | Inflation Rate | Fisher | Real Rates | Investment |

0 | 100.00 | 100.00 | ||||

1 | 102.00 | 5.00% | 2.00% | 3.00% | 2.94% | 105.00 |

2 | 104.50 | 3.00% | 2.45% | 0.55% | 0.54% | 108.15 |

3 | 107.00 | 6.00% | 2.39% | 3.61% | 3.52% | 114.64 |

4 | 109.20 | 2.00% | 2.06% | -0.06% | -0.05% | 116.93 |

5 | 113.00 | 7.00% | 3.48% | 3.52% | 3.40% | 125.12 |

- Inflation Rate
- Year 1: (102/100) -1 =
**2%** - Year 2: (104.5/102) -1 =
**2.45%**

- Year 1: (102/100) -1 =
- Fisher: (Nominal rate - Inflation rate)
- Year 1: (5% - 3%) =
**2%** - Year 2: (3%-2.45%) =
**0.55%**

- Year 1: (5% - 3%) =
- Real Rate
- Year 1: (1+ 0.05) / (1 + 0.02) - 1 =
**2.94%** - Year 2: (1+0.03) / (1+ 0.0245) - 1 =
**0.54%**

- Year 1: (1+ 0.05) / (1 + 0.02) - 1 =
- Investment
- Year 1: 100 x (1+0.05) =
**105** - Year 2: 105 x (1+ 0.03) =
**108.15**

- Year 1: 100 x (1+0.05) =

- Nominal Return (5Yrs): (125.12/100) - 1 =
**25.12%** - Inflation (5Yrs): (113.00/100.00) - 1 =
**13%** - Annualised 5-Year Real Return: (1+0.2512) / (1+ 0.13)
^{⅕}-1 =**2.0581%**

Given those returns and those inflation rates, we have increased our wealth, on average, by **2.0581%** above inflation.

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Expert### Abdulla Javeri

Abdulla’s career in the financial markets started in 1990 when he entered the trading floor of the London International Financial Futures Exchange, LIFFE, and qualified as a pit trader in equity and equity index options. In 1996, Abdulla became a trainer for regulatory qualifications and then for non-exam courses, primarily covering all major financial products.

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