What Is the Real Rate of Return?
The 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, 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:
- The real rate of return adjusts profit for the effects of inflation.
- It is a more accurate measure of investment performance than the nominal rate of return.
- Nominal rates of return 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, then 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 that 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 that you gained after accounting for the effects of inflation.
Real Rate of Return vs. Nominal Rate of Return
Interest rates can be expressed in two ways: as nominal rates, or as real rates. The difference is that nominal rates are not adjusted for inflation, while real rates are. 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 11.25% in 1979 and 13.55% in 1980. Therefore, real rates of return were significantly lower than their nominal-rate counterparts.
So should an investor rely on the nominal rate 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 isn’t entirely accurate until it also accounts for other costs, such as taxes and investing fees.
What is trailing?
Trailing refers to the property of a measurement, indicator, or data series that reflects a past event or observation. It is usually attached to a specified time interval by which the data trail or over which that data are aggregated, summed, or averaged. Trailing data and indicators are used to reveal underlying trends, but can delay recognition of trend turning points. Trailing can also refer to a type of stop order used by traders.
What is the difference between a real or a nominal interest rate?
A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor. A nominal interest rate refers to the interest rate before taking inflation into account. Nominal can also refer to the advertised or stated interest rate on a loan, without taking into account any fees or compounding of interest.
What is inflation?
Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.