## Thursday, April 23, 2009

### 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