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

    Nominal refers to an unadjusted rate, value or change in value. ...
  2. Nominal Interest Rate

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

    The nominal rate of return is the amount of money generated by ...
  4. Real Value

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

    The after-tax real rate of return is the actual financial benefit ...
  6. Nominal Yield

    The nominal yield is the interest rate that the bond issuer promises ...
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. Insights

    Interest Rates: Nominal and Real

    An interest rate is the cost of borrowing money, expressed as a percentage of the loan amount. Interest rates are the primary yardstick for measuring how much return lenders will get. However, ...
  4. 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.
  5. 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 ...
  6. Insights

    Why The Consumer Price Index Is Controversial

    Economists are torn about how to calculate inflation. The Consumer Price Index is a popular, but controversial, measure of inflation in the U.S.
  7. 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.
  8. Insights

    How Inflation Affects Your Net Worth

    When calculating your net worth, don't forget to take inflation into account.
  9. 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. Calculate the difference between nominal value and real value of stock shares

    Explore the impact of real value and nominal value on stock trading. Find out how these values are assigned and what causes ... Read Answer >>
  2. How does inflation affect fixed-income investments?

    Learn about the ways inflation can harm fixed-income investments. Find out how to monitor the impact of inflation using common ... 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 >>
Trading Center