Thread by @theGayan

Finance Fallacy: Real rate = Nominal rate – inflation rate

Most investors rely on this formula, which is WRONG!

Let me tell you why.

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@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)

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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

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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.

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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.

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

Caveat emptor!

If you enjoyed this:
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https://Twitter.com/theGayan/status/1626832251333017606