Real returns — why you divide, not subtract

Almost everyone does this the same way. An investment returns 12% a year, inflation runs at 6%, so the real return is 6%. Subtract one from the other.

It is wrong, and it is wrong in the flattering direction. The real return is 5.66%.

The gap looks trivial. Over twenty years it is not.

Why subtraction fails

Both numbers are growth rates, and growth rates do not add and subtract — they multiply. Over a year, ₹100 becomes ₹112. Over the same year, a basket of goods costing ₹100 becomes ₹106.

So the question is not "112 minus 106". It is: how many baskets could you buy before, and how many after?

With the numbers above: 1.12 ÷ 1.06 = 1.056604, so the real return is 5.6604% — about a third of a percentage point less than subtraction suggests.

This is the same reason the inflation calculator divides rather than subtracts when it converts a future amount into today's money. Prices compound exactly the way returns do.

A third of a percent, for twenty years

A third of a percent sounds like rounding. Compounding does not treat it that way.

Over twenty years at 12% against 6% inflation, a rupee's purchasing power multiplies by $(1.056604)^{20}$, which is 3.0078.

Do it the wrong way — treat the real return as a flat 6% — and you get $(1.06)^{20} = 3.2071$.

That is 6.6% more than the money will actually buy. On a goal of ₹1 crore in today's terms, planning with the wrong figure leaves you about ₹6.6 lakh short of the lifestyle you were aiming at, having done everything else right.

What this does to a long SIP

₹10,000 a month for twenty years, assuming 12% a year, projects to ₹99,91,479. A shade under a crore, which is the number people remember.

At 6% inflation, that sum buys what ₹31,15,390 buys today. About 31% of the purchasing power survives the twenty years.

Nothing has gone wrong in that calculation. The money really does grow to almost a crore in rupees. It is simply that the rupees are smaller by then, and the two facts have to be held together. Every growth calculator on this site has a "Show what this is worth in today's money" option for exactly this reason — it is off by default, because stacking an assumed inflation rate on an assumed return compounds the guesswork, and the rate should be yours to choose.

The case that surprises people

A fixed deposit at 7%, with inflation at 6%:

1.07 ÷ 1.06 = 1.009434, so the real return is 0.94% a year.

Not 1%, and nowhere near 7%. The headline rate is almost entirely a compensation for prices rising, not a gain.

Now assume tax takes 30% of the interest. The nominal return falls to 4.9%, and:

1.049 ÷ 1.06 = 0.989623, a real return of −1.04% a year.

Negative. The deposit is perfectly safe in rupee terms — it cannot fall — and it is still losing purchasing power. That is the trade a deposit makes, and it is worth seeing as a number rather than as a feeling. What tax actually applies depends on your own slab, so treat 30% as an illustration and substitute your own.

This is not an argument against deposits. Certainty has a price and sometimes that price is worth paying; a deposit you can count on in two years is doing a different job from a twenty-year investment. The point is only that "7%" and "what you gain" are not the same number, and the difference is computable.

What inflation rate should you use

There is no correct answer, only a defensible one.

The RBI operates a flexible inflation-targeting framework: the Government, in consultation with the Bank, sets a CPI inflation target under Section 45ZA of the RBI Act, and that target has been 4% with a tolerance band of ±2% — so 2% to 6% — since the framework was adopted in 2016. Many people use 6% for planning, which sits at the top of that band and is therefore cautious rather than optimistic.

Two caveats worth more than the number itself:

• Your inflation is not the headline number. The published index is an average basket. A goal dominated by one kind of spending — education, healthcare, a home — depends on what that item's price does, and it need not move with the average. Test such a goal at a higher rate as well.
• It is an assumption, not a measurement. Nobody knows the next twenty years of inflation. The honest use of this arithmetic is to try several rates and see how much the answer moves — not to find one number and trust it.

What this calculation leaves out

• Tax on gains, beyond the illustration above. Rules differ by instrument and change with the Budget; the figures here are pre-tax unless stated.
• Costs. Expense ratios, exit loads and transaction charges all reduce the nominal return before inflation gets to it.
• Sequence. These formulas assume a steady rate. Real returns arrive in a jumbled order, and for anything you are drawing money out of, the order matters as much as the average.
• Your own basket. The index is an average over a notional household. It is not a measurement of your spending.

The short version

Divide the growth factors, do not subtract the rates. At 12% against 6% the real return is 5.66%, not 6% — and compounded over twenty years the naive version overstates what your money buys by 6.6%. Try it with your own figures in the inflation calculator, or turn on the today's-money option in the SIP calculator and the FD calculator to see both numbers side by side.