What Is the Real Rate of Return?
Real rate of return is the annual percentage of profit earned on an investment, adjusted for inflation. Therefore, the real rate of return accurately indicates the actual purchasing power of a given amount of money over time.
Adjusting the nominal return to compensate for inflation allows the investor to determine how much of a nominal return is real return.
In addition to adjusting for inflation, investors also must consider the impact of other factors such as taxes and investing fees in order to calculate real returns on their money or to choose among various investing options.
Understanding Real Rate of Return
The real rate of return is calculated by subtracting the inflation rate from the nominal interest rate. The formula for real rate of return Is:
Real Rate of Return=(1+Inflation Rate1+Nominal Rate)−1
Inflation can reduce the value of your money, just as taxes chip away at it. Calculating a rate of return in real value rather than nominal value, particularly during a period of high inflation, offers a clearer picture of an investment's success.
- The real rate of return adjusts profit for the effects of inflation.
- It is a more accurate measure of investment performance than nominal return.
- Nominal rates are higher than real rates of return except in times of zero inflation or deflation.
Examples of Real Rate of Return
Assume a bond pays an interest rate of 5% per year. If the inflation rate is currently 3% per year, the real return on your savings is only 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 increases by only 2% in a year.
Considered another way, assume you have saved $10,000 to buy a car but decide to invest the money for a year before buying to ensure you 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.
Real Rate of Return Vs. Nominal Rate
Interest rates can be expressed in two ways: as nominal rates or real rates. The difference is that 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.
In the late 1970s and early 1980s, the profits on double-digit interest rates were eaten up by the effects of double-digit inflation.
An example of the potential gap between 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. Therefore, real rates of return were significantly lower than their nominal counterparts.
So should an investor rely on the nominal or the real rate? Real rates give an accurate historical picture of how an investment performed. But the nominal rates are what you'll see advertised on an investment product.
Other Factors Affecting Real Rate of Return
The problem with real rate of return is that you don't know what it is until it has already happened. That is, inflation for any given period is a "trailing indicator" that can only be calculated after the relevant period has ended.
In addition, the real rate of return figure isn't entirely accurate until it also accounts for other costs, such as taxes and investing fees.