If you are not gaining at least 5.5% from your ZAR based investments a year you are actually losing money! Do you understand why this is? Lets start with some financial terminology.
There are certain words that financial professionals use in very colloquial ways. Often without realising how specialised the jargon actually is.
Two of the most common terms that are used without clients properly understanding them are “nominal returns” and “real returns”.
The difference between the two terms can be explained by one word: inflation.
Inflation is the rate at which the prices of goods and services increase due to a factors such as consumers spending more on goods, cheap access to money (low interest rates), business expanding etc.
Come on we have all heard our parents or grandparents mention how cheap things used to be. Some of us can even remember how back in the day you could get a full meal for under R8. This is the result of inflation.
Inflation is different in each country, with more developed countries (eg. USA) having less volatile inflationary pressures which is often lower than emerging markets (eg. South Africa). This is due to variety of supply and demand factors and links closely to the growth rate of money supply in the country.
Back to our finance jargon: What is the difference?
Real Returns do NOT include inflation and Nominal Returns include inflation.
The relationship can be summarized in the following formula:
REAL RETURN % + INFLATION % = NOMINAL RETURN %
It is not too much of a logical jump than to assume that in a society with inflation, the nominal returns will be higher than a real return. For instance a society with 10% nominal return and inflation of 6%, leaves the Real Return as 4%.
REAL RETURN < NOMINAL RETURN (If there is inflation)
Are you asking what does this have to do with investing?
If you invested your money, would you prefer a nominal return of 7% in country 1 or a nominal return of 3% in country 2 (ignoring foreign exchange)?
As it is with most finance questions the answer is: “it depends“. It would be incorrect to make a decision based of a nominal return because the answer depends on inflation.
Real returns are the best way to compare investments in different geographic locations.
A nominal return of 7% in a country with inflation of 6% is a worse investment decision than investing in a country earning a 3% nominal return with 1% inflation.
At first this seems confusing to some. I want the higher return of 7%! But if you understand what inflation actually is you will see that taking the lower nominal return is financially more beneficial.
Since we are ignoring foreign exchange we will keep both of the currencies in Rands for ease of reference. If you invested R 100 in country 1 and got a return of 7%, you would have R 107 at the end of the year. However in order to buy the same goods you were purchasing at the beginning of the year you would need R 106 (that’s what inflation is right?). The prices of goods went up 6% during the year so your “real return” was only R 1. I.e you only now have R 1 extra to spend compared to the beginning of the year.
Applying the logic to country 2 we would earn a total return of R 103 at the end of the year and since goods only went up 1% we would need R 101 thus making effectively R 2 profit.
So in the above example and because of inflation the nominal return of 3% is actually better than the 7% nominal return.
Nominal vs Real Returns in 2 different countries
It is for this reason that you should never just jump at the first high return you hear. When people say that they are only getting 3% interest in bank accounts in Europe and we in South Africa are getting 8%, dont be too happy.
Remember to always use Real Returns when crossing borders or even when considering how much money you can make. In South Africa we have inflation of about 5.5% which means if you are earning a return of anything lower than this amount you are actually losing money not gaining!
Be vigilant about your “gains” and be hard on your financial advisors.