The real rate of return is the annual percentage of profit earned on an investment, adjusted for inflation. This rate gives a more accurate measure of the actual purchasing power of the returns over time. By adjusting for inflation, investors can determine what portion of their nominal return is truly increasing their wealth.
Investors must also consider taxes and investment fees, alongside inflation, for calculating genuine returns and evaluating various investment options.
The True Essence of Real Rate of Return
The real rate of return can be calculated by subtracting the inflation rate from the nominal interest rate.
Key Insights
- The real rate of return adjusts the profit for inflation effects.
- It provides an accurate measure of investment performance compared to the nominal rate of return.
- Real rates of return are typically lower than nominal rates, except in periods of zero inflation or deflation.
Practical Examples of Real Rate of Return
Assume a bond pays an annual interest rate of 5%. If the inflation rate is 3%, the real return on your savings is only 2%. Despite the 5% nominal return, your actual increase in purchasing power is just 2% over the year.
For instance, imagine you save $10,000 to buy a car but decide to invest the money for a year to maintain a cash cushion. Earning 5% interest, you will have $10,500 after 12 months. However, if inflation raises prices by 3%, the same car now costs $10,300. Your real rate of return, represented by the remaining $200, equates to 2% of your initial investment.
Real Rate of Return vs. Nominal Rate of Return
Interest rates can either be nominal or real. Nominal rates are not adjusted for inflation, while real rates are, causing nominal rates to usually be higher except during deflation.
In the late 1970s and early 1980s, high nominal interest rates were offset by similarly high inflation, showing a considerable gap between nominal and real rates. For example, with prices increasing by 11.25% in 1979 and 13.55% in 1980, real rates of return were much lower.
Should investors prioritize nominal rates or real rates? Real rates give a historical performance view of an investment, while nominal rates are the advertised figures on investment products.
Additional Considerations Affecting Real Rate of Return
It’s important to note that the real rate of return can only be calculated retrospectively, as inflation is a trailing indicator. Furthermore, it doesn’t account for other costs like taxes and fees until those factors are considered.
Defining Key Financial Terms
What Is Trailing?
Trailing refers to measurements or indicators reflecting past events, often linked to a specified time period. They help reveal trends but may delay recognizing changes. In trading, it describes a type of stop order.
Real vs. Nominal Interest Rate
A real interest rate adjusts for inflation, reflecting the true cost of funds for borrowers and real yield for investors. A nominal interest rate is the pre-inflation rate, often featured in advertisements without fees or compounding considerations.
Understanding Inflation
Inflation marks the decline in a currency’s purchasing power over time, shown as a percentage increase in average prices for a selected range of goods and services. It indicates that a unit of currency buys less compared to prior periods.
Related Terms: nominal interest rate, real interest rate, inflation, purchasing power, investment fees, tax impact, nominal return.
References
- Financial Industry Regulatory Authority. “Bond Yield and Return”.
- Federal Reserve Bank of St. Louis. “Getting Real About Interest Rates - The Economic Lowdown Podcast Series”.
- Federal Reserve Bank of St. Louis. “Federal Funds Effective Rate”.
- Federal Reserve Bank of St. Louis. “Inflation, Consumer Prices for the United States”.
