Thursday, April 23, 2009

About Nominal & Real Rates of Return

Nominal Rates of Return

The nominal rate of return is the return that you see most often in the news; most published rates of return are "nominal" rates of return. This is true whether they are stock, or bond returns. For example, if you pay $100 for a CD that will pay you back your $100 plus $5 in interest one year from now, the interest rate is quoted as (5/100=) 5%. Similarly, if you invest $100 in mutual fund XYZ on January 1 and a year later those shares are worth $105, the return on that fund is also 5%. If, in addition, the fund pays you $3 in dividends at the end of the year, the total return will be quoted as ((5+3)/100=) 8%. As an example, here is a graph of stock market nominal return history by year.

While nominal rates of return are "the standard," they can be somewhat misleading -- especially when looking at returns over many years. That's because they ignore the impact of inflation.

Real Rates of Return

"Real" rates of return reflect the impact of inflation. If inflation is 3% per year, then a year from now it will cost $103 to buy what we can buy now for $100. In that case, if we have a $100 investment that earns 3% in nominal terms, a year from now it will represent the same purchasing power as it does today, but no more. That's because goods that you could buy now for $100 will cost you $103 a year from now. In that case, the "real" return is (3% nominal return on investment, minus 3% lost to inflation=) 0%. So, in our examples above, the real return on the CD is (5% - 3%=) 2%; the real total return on XYZ is (8% - 3%=) 5%.

In this blog, returns are always nominal returns -- unless otherwise stated. I call real rates either "real," or "inflation-adjusted."  For example, here's a graph of 10-year Treasury Note Real Returns compared to nominal returns. If I'm looking at long-term nominal returns, I mentally subtract about 3% per year in order to approximate the real rate of return.

Some Implications

It is often important to look at real rates of return when comparing rates of return during different eras. For example, a 12% 1-year CD when inflation was 14% per year, say, during the early 1980's, gave you a real return of (12% - 14%=) -2% -- i.e., you lost 2% of your purchasing power. On the other hand, a 3% CD when inflation is 1% has a (3% - 1%=) 2% real rate of return. The 3% CD is actually a better deal than the 12% CD was!

It's especially important to consider inflation when looking at performance over a long period of time. For example, a $100,000 house purchased 24 years ago and now worth $200,000 has had nominal price appreciation of 3% -- and, assuming inflation has averaged 3%, a real appreciation of 0%. At three percent inflation, prices double approximately every 24 years. Note that this also means that, for example, over a period of 24 years, the purchasing power of a $2,000/month pension would fall to the equivalent of about $1,000/month. Therefore, when doing retirement planning it is critical that you either use real rates of return, or adjust your future income and expenses for inflation.

Related Posts

100 Years of U.S. Inflation History: includes o'view of impact on major asset classes.
100 Years of Inflation-Adjusted Stock Market History: Closing prices adjusted for inflation

Last modified: 3/25/2011

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