NASAA Series 65, Uniform Investment Adviser Law ExaminationClient Investment Recommendations and StrategiesEasy
A client approaches an investment adviser seeking to understand the impact of inflation on their purchasing power. If an investment yields a nominal return of 8% and the inflation rate is 3%, what is the client's real rate of return?
- A5.34%
- B5.00%
- C11.00%
- D4.85%
Show answer & explanationAnswer & explanation
Correct answer: D. 4.85%
The real rate of return is calculated using the formula: ((1 + Nominal Rate) / (1 + Inflation Rate)) - 1. So, ((1 + 0.08) / (1 + 0.03)) - 1 = (1.08 / 1.03) - 1 = 1.04854 - 1 = 0.04854 or approximately 4.85%.
Why the other options are wrong
- A. This is an incorrect calculation.
- B. This is a simple subtraction (8% - 3%), which is an approximation and not precise.
- C. This is an incorrect addition of nominal return and inflation, which would imply a higher purchasing power, the opposite of inflation's effect.
Real Rate of Return
The annual percentage of profit earned on an investment, adjusted for inflation. It measures the true increase in an investor's purchasing power.
- Adjusts nominal return for inflation.
- Indicates the actual increase in purchasing power.
- Calculated using the Fisher Equation: ((1+Nominal)/(1+Inflation)) - 1.
Memory trick: Real return: It's the 'true' gain after inflation eats away your money's power.