What is a 'Nominal Rate Of Return'
A nominal rate of return is the amount of money generated by an investment before factoring in expenses such as taxes, investment fees and inflation. For example, detailed data on a mutual fund might show the fund's nominal rate of return as 10% but also show its return after taxes on distributions and sales of fund shares as only 7%. Investors must look beyond an investment's nominal rate of return to get a true idea of an investment's likely earnings.
BREAKING DOWN 'Nominal Rate Of Return'To illustrate why investors need to look beyond an investment's nominal rate of return, imagine an investor is comparing a municipal bond with a corporate bond. They both have the same nominal rate of return, but their after-tax return is markedly different. In most cases, municipal bonds are tax exempt, while income from corporate bonds is subject to taxation. As a result, if the corporate bond is taxed at 30%, its rate of return is significantly less than the rate of return on the municipal bond, simply due to the presence of capital gains tax.
Nominal Versus After-Tax Rate of Return
As indicated above, the after-tax rate of return of an investment takes the effect of taxation on the investment's returns into account. In most cases, investors pay different amounts of tax on investments, based on the type of investment, the length of time it was held, and the investor's tax bracket. As a result, two different investors may face different after-tax rates of return on an investment even if it is the same investment with the same nominal rate.
Nominal Versus Real Rate of Return
The real rate of return doesn't take taxation into account. Rather, it considers the effect of inflation on an investment. The simple way to calculate the real rate of return is to subtract the inflation rate from the nominal rate. For example, if an investment earns a 10% nominal rate of return in a year with 3% inflation, the real rate of return is 7%.
However, this is a simplified reckoning of these numbers. To calculate the precise rate of return, investors use the following equation: real rate of return = (1+ nominal rate) / (1+ inflation rate) - 1. To continue with the above example, 1 plus the nominal rate is 1.10, and 1 plus the inflation rate is 1.03. Dividing 1.10 by 1.03 yields 1.068, and when 1 is subtracted from this number, it becomes 0.068 or 6.8%.
Nominal Versus Effective Rate of Return
Effective rate of return includes the effects of compounding on an investment. Compounding occurs when interest amounts stack on top of one another. To calculate the effective rate of return, investors divide the annual interest rate or nominal rate of return by the number of compounding periods in a year. They then add this number to 1, and take the sum to the power of the number of compounding periods and, finally, subtract 1 from the sum.