What Is the Nominal Rate of Return?
The nominal rate of return captures the amount of money generated by an investment before accounting for expenses like taxes, investment fees, and inflation. For example, if an investment yields a 10% return, the nominal rate would simply be 10%. After accounting for inflation during the investment period, the actual, or ‘real’, return would generally be lower.
Even with its limitations, the nominal rate of return is incredibly useful since it allows investors to measure the performance of an investment independently of the various tax rates that could apply to different investments.
Key Takeaways
- Precise Performance Measurement: The nominal rate of return helps investors evaluate their portfolio performance before considering external factors such as taxes and inflation.
- Simplicity for Comparison: By using the nominal rate, investors can easily compare the performance of different investments over various time frames with diverse inflation rates.
- Portfolio Analysis: Tracking the nominal rate of return for portfolios aids investors in understanding their investment management over time.
How to Calculate the Nominal Rate of Return
- Start with the Basics: Subtract the initial investment amount (principal) from the current market value of the investment at the end of the period.
- Find the Proportion: Divide the result by the original investment amount.
- Convert to Percentage: Multiply the result by 100 to get the nominal rate of return as a percentage.
What Does the Nominal Rate of Return Tell You?
Understanding this rate encompasses a way for investors to evaluate the portfolio’s performance without external influences like taxes and inflation. You can use it to compare different investments over several periods, even those with varying inflation rates. Monitoring the nominal rates for different segments of the portfolio can also help investors manage their investments more effectively.
Nominal vs. After-Tax Rate of Return
The after-tax rate of return adjusts for the effect of taxes on investment returns. Differential tax treatments based on the investment type, holding period, and investor’s tax bracket mean two investors might experience distinct after-tax returns from an identical nominal return.
For instance, comparing a municipal bond with a corporate bond shows how these are taxed differently. Municipal bonds are typically tax-exempt, while corporate bonds are usually subject to capital gains tax. Hence, despite having the same nominal rate of return, their after-tax returns can vastly differ.
Illustrative Example of a Nominal Rate of Return
Consider an investor who commits $100,000 to a no-fee fund for a year. At year-end, the investment has grown to $108,000. The calculation proceeds as follows:
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The nominal rate of return is:
(\frac{ \left($108,000 - $100,000 \right) }{$100,000} = 0.08 = 8%)
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Hence, the nominal rate of return = 8%.
Distinguishing Between Nominal and Real Rate of Return
The real rate of return factors in inflation and other external influences, offering a clearer picture of the actual earnings on an investment. On the other hand, the nominal rate of return excludes these variables, providing a raw performance measurement.
Limitations of the Nominal Rate of Return
Ignoring inflation and taxes in the nominal rate might present a distorted view of an investment’s performance. For illustration, a 10% nominal return per year, juxtaposed with a 2.5% inflation rate, translates to an actual 7.5% real return. To fully grasp investment gains and account for eroding factors, one should also consider the real rate of return alongside the nominal rate of return.
Related Terms: real rate of return, inflation, tax rates, investment returns, portfolio management.
