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 real return.
What's a Real Rate of Return?
BREAKING DOWN Real Rate of Return
The real rate of return on investment is very important before investing your money. That’s because inflation can reduce the value as time goes on, even if taxes do chip away at it. Investors should also consider whether the risk involved with a certain investment is something they can tolerate given the real rate of return.
Expressing rates of return in real values rather than nominal values, particularly during periods of high inflation, 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.
So should investors use nominal or real rates? Real rates give an accurate, historical picture of how an investment is performing. But since we live in a “here and now” world, nominal rates are what we deal with to move forward. Most people will also want to get an idea of how the high and low price of an investment is relative to its prospects rather than its past performance. In short, how the investment fared when adjusted for inflation five years ago won’t necessarily matter when an investor buys it tomorrow.
Calculating Real Rate of Return
Assume your bank pays you interest of 5 percent per year on the funds in your savings account. If the inflation rate is currently 3 percent per year, the real return on your savings is 2 percent. In other words, even though the nominal rate of return on your savings is 5 percent, the real rate of return is only 2 percent, which means the real value of your savings only increases by 2 percent 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 percent interest, you have $10,500 after 12 months. However, because prices increased by 3 percent 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 percent 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.