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. The purpose of the inflation-adjusted return metric is to reveal 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. The inflation-adjusted return is also known as the real rate of return.
- The inflation-adjusted return accounts for the effect of inflation on an investment's performance over time.
- Also known as the real return, the inflation-adjusted return provides a more realistic comparison of an investment's performance.
- Inflation will lower the size of a positive return and increase the magnitude of a loss.
Understanding Inflation-Adjusted Return
The inflation-adjusted return is useful for comparing investments, especially between different countries because each country's inflation rate is accounted for in the return. In this scenario, without adjusting for inflation across international borders, an investor may get vastly different results when analyzing an investment's performance. The Inflation-adjusted return serves as a more realistic measure of an investment's return when compared to other investments.
For example, assume a bond investment is reported to have earned 2% in the previous year. This appears like a gain. However, suppose that inflation last year was 2.5%. Essentially, this means the investment did not keep up with inflation, and it effectively lost 0.5%.
Assume also a stock that 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 (3%).
Formula for Calculating the 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.
Example of Inflation-Adjusted Return
Assume an investor purchases a stock on January 1 of a given year for $75,000. At the end of the year, on December 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 December 31, the CPI was at a level of 721.
The first step 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% percent.
The second step 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 percent
The third step 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 percent
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.
Nominal Return vs. Inflation-Adjusted Return
Using inflation-adjusted returns is often a good idea because they put things into a very real-world perspective. Focusing on how investments are doing over the long-term can often present a better picture when it comes to its past performance (rather than a day-to-day, weekly, or even monthly glance).
But there may be a good reason why nominal returns work over those adjusted for inflation. Nominal returns are generated before any taxes, investment fees, or inflation. Since we live in a “here and now” world, these nominal prices and returns are what we deal with immediately to move forward. So, most people will want to get an idea of how the high and low price of an investment is—relative to its future prospects—rather than its past performance. In short, how the price fared when adjusted for inflation five years ago won’t necessarily matter when an investor buys it tomorrow.