Question

2. Discuss why investors do not know their investment vehicle (e.g. 401K, 403b, 457 plan, etc.) annual rate (say for the past five years) of return.

Answer 1

The returns which are advertised for any investment are nominal returns which not always give a true picture of returns from a given investment vehicle.

Let us try to understand what nominal returnn mean. This is the return which doesnot take into account the effect of inflation and inflation is a key factor while choosing a given investment vehicle. It is so because infation is something which eats into our investment returns. And hence the returns generated from an investment should always be greater than inflation rate to have a positive returns from an investment. For eg. If the adverstised returns is 3% and prevailing inflation rate is 4%, simplicistically, it can be inferred that the net returns is 3% -4% = -1%.

From this example, it can be concluded the money is gradually decaying by 1% annually instead of growing because in this case we have negative Net return. Here Net returns is called REAL returns.

So, for investors, one should always looks at the REAL returns and not only Nominal returns. and below is hte exact relation between REAL and Nominal returns:

R_nominal = (1 + r_real) * (1 + inflation rate)

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