Inflation-Adjusted Return

What is the 'Inflation-Adjusted Return'

The inflation-adjusted return is the measure of return that takes into account the time period's inflation rate. Inflation-adjusted return reveals the return on an investment after removing the effects of inflation. Removing the effects of inflation from the return of an investment allows the investor to see the true earning potential of the security without external economic forces.

BREAKING DOWN 'Inflation-Adjusted Return'

This real rate of return may be used to compare investments, especially those across international borders, as each country's inflation rate is accounted for in the return. Without adjusting for inflation, an investor may get an entirely different picture from reality when analyzing an investment's performance. For example, assume a bond investment is reported to have earned 2% in the previous year. This looks like a gain, but perhaps inflation last year was 2.5%. Essentially, this means the investment did not keep up with inflation and effectively lost 0.5%.

As another example, assume a stock returned 12% last year and inflation was 3%. An approximate estimate of the real rate of return is 9%, or the 12% reported return less the inflation amount.

Calculating the Inflation-Adjusted Return

Inflation-Adjusted Return

Calculating the inflation-adjusted return requires three basic steps. First, the return on the investment must be calculated. Second, the inflation for the period must be calculated. And third, the inflation amount must be geometrically backed out of the investment's return. As an example:

Assume an investor purchases a stock on Jan. 1 of a given year for $75,000. At the end of the year, on Dec. 31, the investor sells the stock for $90,000. During the course of the year, the investor received $2,500 in dividends. At the beginning of the year, the Consumer Price Index (CPI) was at 700. On Dec. 31, the CPI was at a level of 721.

Step 1 is to calculate the investment's return using the following formula:

Return = (Ending price - Beginning price + Dividends) / (Beginning price) = ($90,000 - $75,000 + $2,500) / $75,000 = 23.3%

Step 2 is to calculate the level of inflation over the period using the following formula:

Inflation = (Ending CPI level - Beginning CPI level) / Beginning CPI level = (721 - 700) / 700 = 3%

Step 3 is to geometrically back out the inflation amount using the following formula:

Inflation-adjusted return = (1 + Stock Return) / (1 + Inflation) - 1 = (1.233 / 1.03) - 1 = 19.7%

Since inflation and returns compound, it is necessary to use the formula in step three. If an investor simply takes a linear estimate by subtracting 3% from 23.3%, he arrives at an inflation-adjusted return of 20.3%, which in this example is 0.6% too high.

RELATED TERMS
  1. Return

    The gain or loss of a security in a particular period. The return ...
  2. Real Rate Of Return

    The annual percentage return realized on an investment, which ...
  3. After-Tax Real Rate Of Return

    The actual financial benefit of an investment after accounting ...
  4. Inflation Protected

    The types of investments that provide protection against inflation ...
  5. Inflation-Protected Security - ...

    A type of fixed-income investment that guarantees a real rate ...
  6. Target Return

    A pricing model that prices a business based on what an investor ...
Related Articles
  1. Markets

    What's a Real Rate of Return?

    A real rate of return is an annual percentage investment return that’s adjusted for inflation, taxes or other factors.
  2. Managing Wealth

    Inflation's Impact On Stock Returns

    When stocks are divided into growth and value categories, the evidence is clear that value stocks perform better in periods of high inflation, and growth stocks perform better during periods ...
  3. Markets

    Coping With Inflation Risk

    Inflation is less dramatic than a crash, but it can be more devastating to your portfolio.
  4. Retirement

    Retirement Planning: Why Real Rates of Return Matter Most

    Here's how to plot your real rate of return, understand your "personal inflation rate" and safeguard your retirement funds against inflation.
  5. Markets

    Corporate Bonds and the Impact of Inflation Risk

    The impact of inflation risk affecting corporate bond returns can be significant. It may even result in a real loss of purchasing power.
  6. Investing

    Explaining Expected Return

    The expected return is a tool used to determine whether or not an investment has a positive or negative average net outcome.
  7. Investing

    How To Calculate Your Investment Return

    How much are your investments actually returning? Find out why the method of calculation matters.
  8. Managing Wealth

    How To Measure Returns On The Series 65 Exam

    An investor who is evaluating the performance of a portfolio manager must take into consideration the impact that any contributions or withdrawals made by the investor will have on the overall ...
  9. Markets

    How Inflation Affects Your Cash Savings

    Prices tend to rise over time and this inflation can cut into the value of your savings. Here are some ways you can manage the situation.
  10. Markets

    A Primer On Inflation

    Inflation has a negative connotation, but is it all bad or does it offer some tangible benefits?
RELATED FAQS
  1. At year-end 2004, the Federal Reserve reported moderate economic growth of 3% ... ...

    The correct answer is c). The real interest rate, also referred to as the inflation-adjusted return, factors the eroding ... Read Answer >>
  2. What can cause the rate of return to be negative?

    Learn how poor company or sector performance, economic turmoil and inflation can cause the rate of return on an investment ... Read Answer >>
  3. How do I calculate yield of an inflation adjusted bond?

    Learn how to calculate the real yield of an inflation-adjusted bond, such as the U.S. Treasury inflation-protected security ... Read Answer >>
  4. What is inflation and how should it affect my investing?

    Inflation, an economic concept, is an economy-wide sustained trend of increasing prices from one year to the next. The rate ... Read Answer >>
  5. What is the difference between a company's annual return and its annualized return?

    Understand the importance of calculating a company's annual return and its annualized return, and learn the differences between ... Read Answer >>
  6. Why are P/E ratios generally higher during times of low inflation?

    Inflation affects equity prices in several ways. Most importantly, investors are willing to pay less for a certain level ... Read Answer >>
Hot Definitions
  1. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  2. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
  3. After-Hours Trading - AHT

    Trading after regular trading hours on the major exchanges. The increasing popularity of electronic communication networks ...
  4. Omnibus Account

    An account between two futures merchants (brokers). It involves the transaction of individual accounts which are combined ...
  5. Weighted Average Life - WAL

    The average number of years for which each dollar of unpaid principal on a loan or mortgage remains outstanding. Once calculated, ...
  6. Real Rate Of Return

    The annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other ...
Trading Center