The True Earning Potential Revealed
The inflation-adjusted return is a pivotal metric that reveals the real earning power of an investment by accounting for inflation over a specific period. By stripping out the influence of inflation, investors can see the true returns of their securities. This measure is also known as the real rate of return.
Key Takeaways
- The inflation-adjusted return encompasses the effect of inflation on an investment over time.
- Known as the real return, it offers a more accurate portrayal of an investment’s performance by adjusting for inflation.
- Inflation diminishes the size of positive returns and exacerbates the size of losses.
Comprehending the Inflation-Adjusted Return
This metric becomes especially invaluable when comparing investments from different countries, as it normalizes varying inflation rates across borders. Taking inflation into account offers clearer insight into an investment’s true performance.
For instance, consider a bond that reports a 2% gain over the previous year, when inflation was 2.5%. In this case, the bond actually lost value in real terms, amounting to a 0.5% reduction.
Another example is a stock yielding 12% during a year of 3% inflation. The real return is around 9%, calculated by subtracting inflation from the nominal return (12% - 3%).
Calculating the Inflation-Adjusted Return
Calculating this metric entails three steps: determining the investment return, calculating the period’s inflation, and adjusting the return geometrically to reflect inflation.
Consider the example of an investor who buys stocks worth $75,000 at the start of the year and sells them for $90,000 at the year-end, receiving $2,500 in dividends. The Consumer Price Index (CPI) was 700 at the beginning and rose to 721 by the end of the year.
First, calculate the return:
Return = (Ending price - Beginning price + Dividends) / Beginning price = (90,000 - 75,000 + 2,500) / 75,000 = 23.3%
Next, determine the inflation rate:
Inflation = (Ending CPI - Beginning CPI) / Beginning CPI = (721 - 700) / 700 = 3%
Finally, adjust for inflation:
Inflation-adjusted return = (1 + Stock Return) / (1 + Inflation) - 1 = (1.233 / 1.03) - 1 = 19.7%
Nominal Return vs. Inflation-Adjusted Return
While nominal returns are essential for understanding immediate gains or losses, inflation-adjusted returns offer a realistic long-term perspective. Nominal returns don’t account for taxes, fees, or inflation but show immediate trends. On the other hand, inflation-adjusted returns present a more true-to-life picture of an investment’s value in real terms.
The Importance of Inflation Adjustment
With rising prices reducing purchasing power, accounting for inflation in investment returns is crucial. For example, $50 in 2013 had the same buying power as $65.23 in 2023. Thus, a $5,000 investment with a 70% nominal return over 10 years yields less in real terms after considering inflation.
The Premier Measure of Inflation
In the U.S., the Consumer Price Index (CPI) by the Bureau of Labor Statistics (BLS) is the most widely recognized measure of inflation. It shapes government policies and borrowing costs, although it doesn’t perfectly cover all living cost changes.
The Final Word: See Beyond the Numbers
Inflation is an unavoidable aspect of economics that affects investment values over time. Understanding the inflation-adjusted return allows investors to gauge the true performance and earning potential of their securities. Whether comparing investments within or across countries, this measure provides a genuine outlook on investments.
Thus, understanding and using the inflation-adjusted return empowers investors to make more informed and profitable decisions by separating real growth from the noise of rising prices.
Related Terms: nominal return, CPI, investing, inflation.
References
- Corporate Finance Institute. “RRR Adjusted for Inflation”.
- U.S. Bureau of Labor Statistics. “CPI Inflation Calculator”.
