Finance Fallacy: Real rate = Nominal rate – inflation rate

Most investors rely on this formula, which is WRONG!

Let me tell you why.

1/6
@CSE_Media #EconomicCrisisLK
First, let's look at the meaning of those terms?

• Nominal int rate: rate of return earned in “money” terms

• Real int rate: rate of return earned in “real” (purchasing power) terms. It's the return after adjusting for effect of #inflation (impact of rising price levels)

2/6
Why the formula is wrong?

“Fisher's Equation” gives the link between:
• Real rate (R),
• Nominal rate (N), and,
• Expected inflation rate (E).

1 + N = (1 + R) * (1 + E)

So,
R = {(1 + N)/(1 + E)} – 1

An “approximation” of this turns out to:
R = N - E

3/6
Yes, this is a common simplification.

But, it can be used only when BOTH nominal rate and inflation rate are very small values.

This may be true for the western world.
But it's not (mostly) true for countries like Sri Lanka.

Let's work some numbers.

4/6
For e.g.:
• If N = 30% and E = 60%
Correct R = -18.75%
Simplified R = -30%

• If N = 30% and E = 25%
Correct R = 4%
Simplified R = 5%

The margin of error in the estimation is much higher, for bigger values of N and E.

5/6
Same goes for your investment decisions and valuations which relied on those simplified real returns.

Caveat emptor!

If you enjoyed this:
• follow me @TheGayan for more insights on #investing
• retweet the top tweet below to share with others

6/6

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More from @theGayan

Feb 19
Domestic Debt Restructuring (DDR): A stitch in time saves nine.

Excerpts of an interview with Dr. @NCdeMel by
@MarianneDavid24

Details why DDR should be done sooner, rather than later.

Links to full interview + paper is on the last tweet.

@CSE_Media #EconomicCrisisLK

1/10
How to tackle a DDR?

So far #SriLanka has talked about restructuring ext debt & not domestic debt.

Our paper shows that current IMF targets for DR are unlikely to deliver a sustainable pathway for econ recovery & debt management, unless rates are brought down by over 10%.
2/10
We don’t see a path for reducing int rates adequately, given high risk in the economy & lack of confidence on financial management.

Int rates are also high because Govt has a huge borrowing appetite simply to repay what has already been borrowed.

That is a vicious cycle.

3/10
Read 10 tweets
Feb 19
🤔 Playing it safe? 🚫
You might be risking everything! 💥

The biggest #risk in life isn't taking risks! 💪

💼 Every decision, every business, has risks and rewards. You can't have your cake and eat it too!

No risk, no reward! 🎂

1/5
@CSE_Media
📚ISO 31,000 defines risk as “effect of uncertainty on objectives”.

There’s no free lunch. 🍚
Nothing ventured - nothing gained.

So don't focus on the risk.
Rather, focus on the objective! 🎯

🔍 Don't miss out on opportunities because you're scared of uncertainty!

2/5
An event that seems certain may not happen. Something that seems unlikely could turn out to be a huge win! 🎉

🌟 Remember, luck and risk doesn't discriminate!

💡“You can be smart and end up wrong. Or dumb and end up right. That’s how luck and risk work” - @morganhousel

3/5
Read 5 tweets
Feb 9
History Repeats:
@CBSL imposes restrictions on discretionary payments (DPs) of banks

What?
CBSL imposed set of restrictions on DPs of banks.

When?
With immediate effect.

These mirror the set of restrictions issued in May 2022, for Financial Year (FY) 2022.

1/9
@CSE_Media
Why?
This was issued considering:

• possible adverse impact on liquidity and capital position of banks due to the current economic conditions, and,

• importance of maintaining appropriate levels of liquidity and capital levels to ensure sustainability.

2/9
So what?

Given current challenges, this aims to ensure stability of the banking system and preserve valuable foreign exchange.

However, this will depress the equity valuations of banks in the perspective of investors.

3/9
Read 9 tweets
Feb 3
#SriLanka ISB holders Group insists that Domestic Debt is "reorganised"

This has both good as well as bad sides.

Let me tell you all about it, in English.

1/12

@CSE_Media #EconomicCrisisLK
The "Group"
• Known as "an ad-hoc creditor committee"
• Consists of 100+ foreign investors
• Led by a steering committee of 10+ members
• Represents over 55%+ of ISBs non- domestic holdings
• Advised by Rothschild and White & Case

Source: Min. of Finance (23.09.2022)

2/12
Summary

• They are ready to hold debt restructuring talks - quickly and effectively

• They acknowledge Sri Lankan authorities’ engagement with official creditors toward a resolution of the current crisis and restoration of debt sustainability.

3/12
Read 12 tweets
Jan 16
Want to get ahead in the #investing game?

Yes, it is a game. One which we all eventually play (or pay).

I've been managing investments for the last 15+ years.

Follow this 11 simple steps and you'll be way ahead of the curve.

Note:
NOT investment advice!

1/13
@CSE_Media
1. A plan is better than no plan

Define your investment objectives (where you want to be).

Then, compare where you want to be vs. where you are now, and draw a path to reach where you want to.

Plans will change. But you'll know what changed and how it impacted your path.

2/13
2. Never invest in what you don’t understand

If you don't understand:
• how your investment works, and,
• how it's supposed to make you money,
it's NOT the right investment for you.

It might be right for someone else. Might be right for everyone else. But not for you.

3/13 Image copyright belongs to the original creator
Read 13 tweets
Jan 14
#IMF MD on Debt Restructuring (Summarised)

What's the biggest problem internally for China?

China is still a developing country. So, China will try to offer support to all developing countries, but, they expect to be paid back because it's a developing country.

1/4
@CSE_Media
So, a haircut in Chinese context is politically very difficult.

But they understood that there are ways in which they can reach the equivalent of a haircut by stretching maturities, reducing or eliminating interest rates & payments.

Paris Club is also engaging with China.

2/4
There may be a way to reach the same objective of reducing debt burden.

Yes, it's better if debt reduction is done upfront (haircut), compared to reprofiling.

We emphasise the value for China as a lender to have their exposure to countries defined in a rational way.

3/4
Read 4 tweets

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