What is a 'Real Rate Of Return'
A real rate of return is the annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other external effects. This method expresses the nominal rate of return in real terms, which keeps the purchasing power of a given level of capital constant over time. Adjusting the nominal return to compensate for factors such as inflation allows you to determine how much of your nominal return is actually real return.
BREAKING DOWN 'Real Rate Of Return'Particularly during periods of high inflation, expressing rates of return in real values rather than nominal values offers a clearer picture of an investment's value.
Nominal vs. Real Values
Interest rates can be expressed in two ways: as nominal rates or real rates. The difference is nominal rates are not adjusted for inflation, while real rates are adjusted. As a result, nominal rates are almost always higher, except during those rare periods when deflation, or negative inflation, takes hold.
An example of the potential dichotomy of nominal and real rates of return occurred in the late 1970s and early 1980s. Double-digit nominal interest rates on savings accounts were commonplace but so was double-digit inflation; prices increased by 11.3% in 1979 and 13.5% in 1980. Accordingly, real rates of return were significantly lower than their nominal counterparts.
Calculating Real Rate of Return
Assume your bank pays you interest of 5% per year on the funds in your savings account. If the inflation rate is currently 3% per year, the real return on your savings is 2%. In other words, even though the nominal rate of return on your savings is 5%, the real rate of return is only 2%, which means the real value of your savings only increases by 2% during a one-year period.
Put another way, assume you have $10,000 to purchase a car that costs the same amount but decide to invest the money for a year before buying, to hopefully have a small cash cushion left over after getting the car. Earning 5% interest, you have $10,500 after 12 months. However, because prices increased by 3% during the same period due to inflation, the same car now costs $10,300. Consequently, the amount of money that remains after you buy the car, which represents your increase in purchasing power is $200, or 2% of your initial investment. This is your real rate of return, as it represents the amount you gained after accounting for the effects of inflation.