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 long-term savings. The client has $500,000 currently and expects an average annual return of 7% on their investments. If inflation averages 3% per year, what is the approximate real rate of return the client can expect?
- A4.88%
- B10.00%
- C3.88%
- D4.00%
Show answer & explanationAnswer & explanation
Correct answer: C. 3.88%
The approximate real rate of return is calculated using the formula: (1 + Nominal Rate) / (1 + Inflation Rate) - 1. So, (1 + 0.07) / (1 + 0.03) - 1 = 1.07 / 1.03 - 1 = 1.03883 - 1 = 0.03883 or 3.88%. A simpler approximation (Nominal Rate - Inflation Rate) would yield 4%, but the more accurate calculation is preferred.
Why the other options are wrong
- A. This is an incorrect calculation; it does not accurately reflect the real rate of return.
- B. This is an incorrect calculation, representing the sum of the nominal rate and inflation, not the real rate.
- D. This is the approximate real rate using simple subtraction, which is less accurate than the formula.
Real Rate of Return
The rate of return on an investment after adjusting for the effects of inflation, indicating the true increase in purchasing power.
- Crucial for long-term financial planning.
- Nominal return - inflation rate is an approximation.
- Calculated as [(1 + Nominal Return) / (1 + Inflation Rate)] - 1.
Memory trick: Inflation burns wealth, so calculate the real rate to see true gains.