What Is the 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 factors. 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.
The Formula for the Real Rate of Return Is
Real rate of return=Nominal interest rate−Inflation rate
How to Calculate the Real Rate of Return
The real rate of return is calculated as subtracting the inflation rate from the nominal interest rate.
What's a Real Rate of Return?
What Does the Real Rate of Return Tell You?
Knowing the real rate of return of an investment is very important before investing your money. That’s because inflation can reduce the value as time goes on, just as taxes also 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.
- The real rate of return is the return adjusted for inflation or other factors.
- Adjusting the rate of return offers a better measure of investment performance and allows for a more effective risk versus reward measurement.
- Nominal rates are usually always higher than the real rate of return.
Example of How to Use 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 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.
Consider, alternatively, the nominal rate for a Bank of America bond that matures on Nov. 15, 2024. The bond pays an 8.57% nominal rate as of January 2019. The inflation rate for 2018 was 1.9%, per the U.S. Labor Department. The real rate of return on the bond is 6.67%, or 8.57% less 1.9%.
The Difference Between the Real Rate of Return and 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.
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 you'll see advertised on an investment product.
Limitations of Using Real Rate of Return
The main limitation of the real rate of return is that it might not always be accurate as it doesn’t always account for other costs, such as taxes and opportunity cost. There’s also inflation, which can be miscalculated. As well, most inflation rates are quoted on a trailing basis, which isn't indicative of what inflation will be going forward.
Learn More About Real Rate of Return
To learn more about the difference between the real rate of return and nominal rates, read about the difference between real and nominal interest rates.