Suppose Jean Splicer, an investor, buys $100,000 of shares of stock in a diversified bundle of Bio-tech firms and exactly one year later sells those shares for $108,000. If the value of the CPI at the date of Jean's purchase was 160, and rose by the sale date one year later to 168, what was her real rate of return on this investment?
To calculate the real rate of return on an investment, we need to adjust for inflation. In this case, we'll use the Consumer Price Index (CPI) to account for inflation.
First, we determine the inflation rate over the one-year period. We can calculate this by dividing the difference in CPI values by the initial CPI value:
Inflation Rate = (Final CPI - Initial CPI) / Initial CPI
Inflation Rate = (168 - 160) / 160 = 0.05 or 5%
Next, we calculate the nominal rate of return, which is the percentage increase in the investment value:
Nominal Rate of Return = (Sale Value - Purchase Value) / Purchase Value
Nominal Rate of Return = ($108,000 - $100,000) / $100,000 = 0.08 or 8%
Finally, we calculate the real rate of return by adjusting the nominal rate of return for inflation:
Real Rate of Return = (1 + Nominal Rate of Return) / (1 + Inflation Rate) - 1
Real Rate of Return = (1 + 0.08) / (1 + 0.05) - 1 = 0.027 or 2.7%
Therefore, Jean Splicer's real rate of return on this investment is approximately 2.7%.