What is the real interest rate? What does it mean? What were market returns like when real rates were positive, negative?

The real interest rate is an essential concept in finance that measures the inflation-adjusted return on an investment. It is the nominal interest rate minus the rate of inflation. For example, if the nominal interest rate on a bond is 6% per year, and the inflation rate is 2% per year, the real interest rate would be 4% per year.

The real interest rate is important because it reflects the true value of an investment after taking into account the erosion of purchasing power caused by inflation. Investors must be mindful of inflation because it can erode the value of their investment returns over time.

When the real interest rate is positive, it means that the return on an investment is higher than the rate of inflation. This scenario benefits investors because they are able to earn a real return on their investment, which is the difference between the nominal return and the rate of inflation. For example, if the nominal return on an investment is 5%, and the rate of inflation is 2%, the real return would be 3%.

When the real interest rate is negative, it means that the rate of inflation is higher than the nominal interest rate. This scenario can be problematic for investors because the inflation rate is eroding the value of their investment returns. In other words, the real value of their investment is declining over time.

Historically, market returns have varied widely depending on the level of real interest rates. When real interest rates are high, as they were in the 1980s and early 1990s, market returns tend to be lower because higher interest rates can put a damper on economic growth. However, high real interest rates can be beneficial for investors who hold fixed income investments like bonds or CDs because they can earn a higher rate of return.

On the other hand, when real interest rates are low or negative, as they have been in recent years, market returns tend to be higher because lower interest rates stimulate economic growth and encourage investment in riskier assets like stocks. Low or negative real interest rates can be detrimental for savers who rely on fixed income investments for income because the returns are low, which can lead to lower retirement income.

It is important to note that the real interest rate is not the only factor that influences investment returns. Other factors include market volatility, geopolitical events, and company-specific factors like earnings growth and financial health.

In conclusion, the real interest rate is a critical concept in finance that measures the inflation-adjusted return on an investment. It is the nominal interest rate minus the rate of inflation. When the real interest rate is positive, investors can earn a real return on their investment, while a negative real interest rate can erode the value of their investment returns over time. Market returns have varied widely depending on the level of real interest rates, but it is important to remember that other factors can also influence investment returns.

The real question is do you know how the Real Interest Rate affects, or is affecting, your investments and retirement in the long run?  The Federal Reserve met again on  March 21-22, which was this past Tuesday.  Our job is to not only be ready for any change in the interest rate, but more importantly, how it will correlate to your portfolio and retirement plan as a whole.  If you are interested in being proactive instead of reactive, planning for not only this year but the future years, and having a partner in progress please reach out to me.

Please feel free to reach out for help with any of your investment, insurance, or financial planning needs. 

Michael Torrence mtorrence@alphawealthfunds.com