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What Is the Real Rate of Return?
Let me explain what the real rate of return really means. It's the annual percentage profit you earn on an investment, but adjusted for inflation. This adjustment shows you the actual purchasing power of your money over time.
When you adjust the nominal return for inflation, you can see how much of that return is genuinely real. You also need to factor in things like taxes and investing fees to get the full picture when calculating real returns or comparing investment options.
Understanding Real Rate of Return
You calculate the real rate of return by subtracting the inflation rate from the nominal interest rate. That's the straightforward way to do it.
Key Takeaways
- The real rate of return adjusts profit for inflation's effects.
- It's a more accurate measure of investment performance than the nominal rate.
- Nominal rates are higher than real rates except in times of zero inflation or deflation.
Examples of Real Rate of Return
Suppose a bond pays 5% interest per year, and inflation is at 3%. Your real return is just 2%. Even with a 5% nominal return, the real value of your savings only grows by 2% after inflation.
Think about saving $10,000 for a car but investing it for a year first. At 5% interest, you end up with $10,500. But if prices rise 3%, the car now costs $10,300. What's left after buying it is $200, which is your 2% real return— that's the gain in purchasing power after inflation.
Real Rate of Return vs. Nominal Rate of Return
Interest rates come in nominal or real forms. Nominal rates ignore inflation, while real rates adjust for it. That's why nominal rates are usually higher, except in rare deflationary periods.
Back in the late 1970s and early 1980s, double-digit interest rates were common, but so was double-digit inflation—11.25% in 1979 and 13.55% in 1980. Real returns were much lower than nominal ones then.
You might wonder which to rely on. Real rates give you an accurate historical view of performance, but nominal rates are what you'll see advertised on products.
Other Factors Affecting Real Rate of Return
The issue with real rate of return is you only know it after the fact, since inflation is a trailing indicator calculated post-period. Plus, it's not fully accurate without including taxes and fees.
What Is Trailing?
Trailing means a measurement or indicator reflects past events, often over a specific time interval. It's useful for trends but can lag in spotting changes. Traders also use it for stop orders.
What Is the Difference Between a Real or a Nominal Interest Rate?
A real interest rate adjusts for inflation to show the true cost to borrowers or yield to lenders. A nominal rate is the stated rate before inflation, without fees or compounding.
What Is Inflation?
Inflation is the decline in a currency's purchasing power over time, measured by rising prices of goods and services. Expressed as a percentage, it means your money buys less than before.
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