Loading the player...

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.

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.

RELATED TERMS
  1. Nominal Interest Rate

    The nominal interest rate is the interest rate before taking ...
  2. Nominal Rate Of Return

    The nominal rate of return is the amount of money generated by ...
  3. Real Interest Rate

    A real interest rate is one that has been adjusted for inflation, ...
  4. Fisher Effect

    The Fisher effect is an economic theory created by Irving Fisher ...
  5. Real Value

    Real value is nominal value adjusted for inflation.
  6. After-Tax Real Rate Of Return

    The after-tax real rate of return is the actual financial benefit ...
Related Articles
  1. Investing

    Interest Rates Explained: Nominal, Real, Effective

    Interest rates are divided into subcategories. Smart investors look beyond the nominal or coupon rate of a bond or loan to see if it fits their objectives.
  2. Investing

    Understanding the Fisher Effect

    The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate.
  3. Trading

    An introduction to the international fisher effect

    The Fisher models have the ability to illustrate the expected relationship between interest rates, inflation and exchange rates.
  4. Investing

    Introduction to Treasury Inflation-Protected Securities (TIPS)

    Learn how U.S. Treasury Inflation Protected Securities (TIPS) can be easy and highly beneficial to your portfolio. They are the only securities that provide a guaranteed real rate of return by ...
  5. Insights

    The Taylor Rule: An Economic Model for Monetary Policy

    Learn about the The Taylor Rule, an interest rate forecasting model that's helped central banks around the world adjust their rates to balance out inflation.
  6. Insights

    Why The Consumer Price Index Is Controversial

    Find out why economists are torn about how to calculate inflation.
  7. IPF - Banking

    How Inflation Affects Your Cash Savings

    Prices tend to rise over time and this inflation can cut into the value of your savings. Here are some ways you can manage the situation.
  8. Insights

    Inflation's Impact on Stock Returns

    Learn about the impact inflation can have on stock returns. Find information on what types of stocks perform during times of high inflation or low inflation.
  9. Financial Advisor

    Corporate Bonds and the Impact of Inflation Risk

    The impact of inflation risk affecting corporate bond returns can be significant. It may even result in a real loss of purchasing power.
  10. Investing

    The Money Market: A Look Back

    Learn how past inflationary periods can predict future real rates of return for cash investments.
RELATED FAQS
  1. What is the rate of return I can expect on a savings account?

    Find out what kind of return you can expect from the cash balance in your savings account and why interest rates have been ... Read Answer >>
  2. Is real GDP a better index of economic performance than GDP?

    Learn why real GDP is a better index for expressing the output of an economy, as it takes into account the factors that distort ... Read Answer >>
  3. 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 >>
  4. When do economists use real GDP instead of GDP?

    Learn about the purposes for which economists rely on real GDP. Find out how real GDP is calculated and how it is important ... Read Answer >>
Hot Definitions
  1. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  2. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  3. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  4. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  5. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  6. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
Trading Center