## 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.

Next Up

## 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 percent in the previous year. This looks like a gain, but perhaps inflation last year was 2.5 percent. Essentially, this means the investment did not keep up with inflation and effectively lost 0.5 percent.

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

## 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. 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% percent.

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 percent

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 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 percent from 23.3 percent, he arrives at an inflation-adjusted return of 20.3 percent, which in this example is 0.6 percent too high.

## Using Nominal vs. Inflation-Adjusted Returns as a Tool

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 longer 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.

RELATED TERMS
1. ### Inflation Trade

An inflation trade is an investing scheme or trading method that ...
2. ### After-Tax Real Rate Of Return

The after-tax real rate of return is the actual financial benefit ...
3. ### Price Inflation

Price inflation is the increase in a collection of goods and ...
4. ### Annualized Total Return

Annualized total return gives the yearly return of a fund calculated ...
5. ### Real Interest Rate

A real interest rate is one that has been adjusted for inflation, ...
6. ### Total Return

Total return is a performance measure that reflects the actual ...
Related Articles
1. Insights

### How Inflation Rates Impact Your Retirement Savings

Understanding the risks and likely rate of inflation can help investors craft a strategically, well-diversified retirement portfolio.
2. Investing

### 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.
3. Insights

### The Importance Of Inflation And GDP

Learn the underlying theories behind these concepts and what they can mean for your portfolio.
4. Investing

### Shield Your Portfolio From Inflation For Real Returns

Inflation-protected securities are part of the equation, but they're not a perfect solution.
5. Investing

### Best ETFs for Inflationary Worries

Inflation may have been muted over the last few years, but that doesn’t mean investors should forget about it.
6. Insights

### Should You Worry About the U.S Inflation rate?

Understand how inflation is measured, how U.S. inflation compares to other countries, and if investors should be concerned with rising inflation.
7. Retirement

### How Inflation Eats Away at Your Retirement

When calculating how much money you need to comfortably retire, it's important to factor in how much inflation can chip away at your savings.
RELATED FAQS
1. ### 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 >>
2. ### What is inflation and how should it affect my investing?

The rate of inflation is important as it represents the rate at which the real value of an investment is eroded and the loss ... Read Answer >>
3. ### How does inflation affect fixed-income investments?

Learn about the ways inflation can harm fixed-income investments. Find out how to monitor the impact of inflation using common ... Read Answer >>
4. ### What is the Difference Between Real and Nominal Interest Rates?

Learn about nominal interest rates and real interest rates and the difference between the two (hint: one of them takes into ... Read Answer >>
Hot Definitions
1. ### Investment Advisor

An investment advisor is any person or group that makes investment recommendations or conducts securities analysis in return ...
2. ### Gross Margin

A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
3. ### Inflation

Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
4. ### Discount Rate

Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
5. ### Economies of Scale

Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
6. ### Quick Ratio

The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.