Nominal rate of return refers to the actual percentage increase or decrease in the value of an investment without adjusting for inflation. This means it measures the change in the investment’s value over time in terms of the currency invested, without considering how the purchasing power of that currency may have changed due to inflation. On the other hand, the real rate of return adjusts the nominal rate for inflation, providing a more accurate measure of the true purchasing power gained or lost from an investment.
Nominal vs. Real Rate of Return
Nominal vs. Real Rate of Return — Understanding the difference between nominal and real rates of return is key to accurately evaluating an investment’s performance. While both metrics offer valuable insights, grasping their distinctions is crucial for making well-informed financial decision.
What Are Nominal and Real Rates of Return?
Nominal Rate of Return
The nominal rate of return is straightforward, indicating the percentage change in the value of an investment over a given period. For instance, if you invest $1,000 in a bond with a 5% annual interest rate, your nominal rate of return would be 5%. This means that at the end of the year, you would earn $50 in interest ($1,000 * 0.05 = $50).
Nominal RoR = (Current Value − Initial Value / Initial Value)×100 %
Example
Let’s say you invested $10,000 in a stock at the beginning of the year, and at the end of the year, the value of your investment is $12,000.
Using the formula for nominal rate of return:
Nominal RoR = ((12,000 – 10,000) / 10,000) × 100%
= (2,000 / 10,000) × 100%
= 0.20 × 100%
Nominal RoR = 20%
So, the nominal rate of return on your investment for the year is 20%.
Real Rate of Return
The real rate of return adjusts the nominal rate to account for inflation, providing a more accurate measure of the purchasing power gained or lost from an investment. Inflation erodes the value of money, so the real rate offers a clearer picture of wealth growth.
Real Rate of Return = ((1+ Nominal RoR) / (1+Inflation rate) -1)x100%
Example
If the inflation rate is 3%, the real rate of return on your bond investment with a nominal rate of 5% would be 1.94%, calculated as follows:
Real Rate of Return = ((1+ Nominal RoR) / (1+Inflation rate) -1)x100%
((1+0.05) / (1+0.03) -1) * 100% = 1.94%
This means that after adjusting for inflation, your investment’s true purchasing power increased by 1.94%.
Key Differences Between Nominal and Real Rates of Return
| Aspect | Nominal Rate | Real Rate |
|---|---|---|
| Inflation Adjustment | Does not account for inflation. | Adjusts for inflation to reflect true purchasing power. |
| Focus | Measures raw growth in value. | Measures purchasing power gained or lost. |
| Usefulness | Good for quick calculations. | Essential for assessing long-term wealth growth. |
| Decision-Making Impact | May mislead if inflation is high. | Provides a realistic basis for financial planning. |
Practical Applications of Nominal and Real Rates
Investment Decision-Making
Investors use real rates to assess long-term growth potential. For instance:
- Retirement Planning: If you plan to retire in 20 years, knowing the real rate helps estimate how much your investments will truly grow, considering inflation.
- Real Estate vs. Bonds: Real rates allow for a better comparison of investment types, accounting for inflation’s impact on returns.
Economic Analysis
Economists and policymakers rely on real rates to evaluate the effectiveness of monetary policy and measure economic growth:
- For example, if nominal GDP grows by 6% but inflation is 4%, the real GDP growth is only 2%.
Financial Planning
For individuals, understanding real rates helps:
- Adjust savings and investment strategies to preserve purchasing power.
- Avoid overestimating the growth of investments in high-inflation environments.
Examples from the Real World
Scenario 1: Historical Perspective
During the 1970s in the U.S., inflation rates were exceptionally high, averaging around 7-8% annually. Investors who focused solely on nominal returns found their purchasing power significantly eroded. For instance:
- A nominal return of 10% during a year with 8% inflation resulted in a real return of only 1.85%.
Scenario 2: Fixed-Income Investments
Consider an investor holding a bond with a 5% nominal interest rate in a year with 3% inflation. The real return would be 1.94%, demonstrating how inflation diminishes the perceived profitability of fixed-income securities.
How to Use This Information
Evaluate Your Investments
- Calculate both nominal and real rates to understand the true value of your returns.
- Use historical inflation data from reliable sources like the U.S. Bureau of Labor Statistics to make accurate assessments.
Plan for the Future
- Incorporate expected inflation into your financial models.
- Adjust investment strategies to focus on assets that historically outpace inflation, such as equities or real estate.
Stay Informed
- Regularly monitor inflation trends and economic indicators.
- Reassess your investment portfolio to ensure it aligns with real return goals.
Key takeaways
- Real Returns Matter: They empower investors to make informed decisions and preserve wealth over time.
- Nominal vs. Real Returns: Nominal returns reflect raw growth, while real returns adjust for inflation, offering a clearer picture of true wealth growth.
- Inflation’s Role: Inflation erodes purchasing power, making real returns crucial for evaluating long-term financial performance.
Further Reading:
Nominal Vs. Real Cash Flow
Cost of Capital: What It Is & How to Calculate