Turn any stated interest rate or return into a real return after inflation.
Find the interest rate on one account you hold, such as a savings account or a fixed deposit, and write it down. Next to it you will write a second number: how much prices rose over the same year. With those two numbers you can tell whether the money in that account is gaining or losing ground. Once you know the method, the answer takes about ten seconds to work out.
Say a fixed deposit has just matured and the bank's letter says it earned 3% over the year. Over the same year your groceries went up, your phone bill went up, and your parents' medical bills went up. The 3% tells you how many more dollars you have. What matters is how much better off you are in terms of what the money can buy. All the rates used here are examples, chosen to make the arithmetic easy to follow.
Nominal return is the percentage your balance grew in dollars. It is the rate on your statement, the one banks advertise and the one shown in your app.
Real return is how much more your money can buy after inflation is taken into account. It is the number you actually care about. It combines two movements: your balance going up and the value of each dollar going down. Lesson 4.1, "Inflation means the same dollar buys less each year", showed purchasing power falling while a balance stayed the same. Real return builds on that by letting the balance move as well.
If your balance grows 3% and prices also rise 3%, your nominal return is 3% and your real return is zero. You have more dollars, but they buy exactly what the old balance bought.
The quick rule is that real return is roughly the nominal return minus the inflation rate. Take the nominal return, subtract the inflation rate, and the result is the approximate real return.
At 3% nominal and 2% inflation, the real return is about 1%. At 5% nominal and 2% inflation, it is about 3%. A savings account paying 0.5% while inflation runs at 2.5% gives a real return of about minus 2%.
This estimate is fast and close enough for most decisions, especially when both figures are small. Use it in your head when a banker or an advertisement quotes you a rate.
The subtraction is slightly off because inflation also applies to the interest you earn, as well as to the original sum. The exact formula is (1 + nominal return) / (1 + inflation) - 1. To use it:
Add 1 to the nominal return, written as a decimal. Add 1 to the inflation rate, written as a decimal. Divide the first number by the second. Subtract 1. The result is the real return.
For 3% nominal and 2% inflation, 1.03 / 1.02 is about 1.0098. Subtract 1 and you get 0.0098, a real return of about 0.98%, just under the quick estimate of 1%.
In dollars, S$10,000 at 3% becomes S$10,300 after a year. Divide S$10,300 by 1.02 and you get about S$10,098 in last year's prices. You are S$98 better off in purchasing power, rather than the S$100 the interest figure suggests.
For the savings account, 1.005 / 1.025 is about 0.9805, a real return of about minus 1.95%, close to the quick estimate of minus 2%.
At low rates the two methods differ by a few hundredths of a percent. The gap widens at higher rates: with 10% nominal and 8% inflation, the shortcut gives 2% and the exact answer is about 1.85%. In a spreadsheet, always use the exact formula, because it costs nothing extra.
Real return is below zero whenever the rate you earn is lower than inflation. When that happens, the balance still rises every month and the app still shows interest credited, but each year the money buys a little less. It is easy to miss because nothing on the screen goes down.
Take S$20,000 earning 0.5% while prices rise 2.5% a year. After a year the balance is S$20,100. That S$20,100 is worth about S$19,610 in last year's money. The account shows a gain of S$100, while you have lost almost S$400 of purchasing power.
None of this means cash is a bad place to keep money. You need cash for spending and for emergencies, and the course "The Singapore personal finance system, end to end" covers how much of it to hold. Module 5 looks at what you give up for a higher return. What you need is the real return on every place you keep money, so that if you leave cash idle for years, you have chosen to.
Working out the real return on an account takes two numbers: the rate you actually earn and an inflation figure. Take the rate you earn on each account from your money map. For inflation, look up the latest published annual figure from the Department of Statistics on its SingStat website, rather than a number you remember from the news. Then apply the formula to each line. Your money map from lesson 1.4 already has the first number on every line, so all that is left is to look up the second and apply the formula.
For each account in your money map, write down its rate and work out the real return using the latest inflation figure from the Department of Statistics.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).