Negative real return

What Is Negative Real Return?

A negative real return occurs when the return on an investment or savings account is less than the rate of inflation over the same period, leading to a loss in actual purchasing power. This concept is fundamental to understanding true investment returns within the broader field of Investment Performance and Portfolio Management. While an investment might show a positive nominal gain, if inflation outpaces that gain, the investor's ability to buy goods and services with their money diminishes, resulting in a negative real return.

History and Origin

The concept of real versus nominal values has been understood by economists for centuries, with early observations noting that the true value of money and returns is affected by changes in price levels. However, the explicit focus on "real return" became particularly prominent in modern finance, especially as economies experienced periods of sustained inflation throughout the 20th century. During such periods, investors and policymakers recognized that simply looking at a stated interest rate or investment gain was insufficient to gauge actual wealth accumulation. The systematic measurement of inflation, notably through indices like the Consumer Price Index (CPI), which began to be regularly collected and published by governmental bodies like the U.S. Bureau of Labor Statistics (BLS) with data extending back to 1913, allowed for more precise calculations of real returns.¹⁰,⁹ The need to protect capital from the eroding effects of inflation led to the development of financial instruments like Treasury Inflation-Protected Securities (TIPS) in the late 20th century, specifically designed to offer a real return.⁸

Key Takeaways

• A negative real return means that the increase in an investment's value is less than the rate of inflation, resulting in a decline in actual purchasing power.
• This phenomenon is particularly detrimental during periods of high inflation, as it erodes wealth even if nominal gains are observed.
• Understanding real returns is crucial for effective long-term financial planning and preserving wealth.
• Fixed-income investments, such as bonds or savings accounts, are highly susceptible to negative real returns if their interest rates do not keep pace with inflation.
• Protecting against negative real returns often involves strategies like investing in inflation-indexed securities or assets historically known to perform well during inflationary environments.

Formula and Calculation

The calculation of a negative real return involves comparing an investment's nominal return to the rate of inflation. The approximate formula for real return is:

For a more precise calculation, especially when dealing with higher rates, the following formula is used:

Where:

• Nominal Return: The stated percentage gain or loss on an investment over a specific period.
• Inflation Rate: The percentage increase in the general price level of goods and services over the same period, often measured by the change in the Consumer Price Index.⁷

For example, if an investment yields a nominal return of 5% and the inflation rate is 7%, the approximate real return would be 5% - 7% = -2%. Using the precise formula:

This indicates a negative real return, meaning the investment's purchasing power decreased by 1.87%.

Interpreting the Negative Real Return

Interpreting a negative real return means recognizing that despite any positive numerical gains an investment may show, its actual economic value has declined. For instance, if a savings account offers a 1% annual interest rate and inflation is running at 3%, the account holder experiences a negative real return of approximately -2%. This implies that the money in the account, while numerically increasing, can buy less at the end of the year than it could at the beginning.

Investors frequently encounter negative real returns during periods of unexpected or persistently high inflation, especially with traditionally "safe" assets like cash, certificates of deposit (CDs), or conventional fixed income securities. This erosion of purchasing power can significantly undermine long-term financial goals, making it essential for investors to consider inflation when evaluating their overall investment strategy. The goal is generally to achieve a positive real interest rate on investments to ensure wealth preservation and growth.

Hypothetical Example

Consider an individual, Sarah, who invests $10,000 in a certificate of deposit (CD) with a stated annual interest rate of 2%. Over the same year, the Consumer Price Index (CPI) indicates an inflation rate of 4%.

1. Calculate Nominal Return:
   Sarah's investment grows by 2%, so at the end of the year, her CD is worth:
   $10,000 \times (1 + 0.02) = $10,200

2. Calculate the Real Return:
   Using the approximate formula for real return:
   Real Return $\approx$ Nominal Return - Inflation Rate
   Real Return $\approx$ 2% - 4% = -2%

   Using the precise formula:
   Real Return = (\frac{(1 + 0.02)}{(1 + 0.04)} - 1 = \frac{1.02}{1.04} - 1 \approx 0.980769 - 1 = -0.01923) or -1.92%

Despite her CD showing a nominal gain of $200 ($10,200 - $10,000), Sarah has experienced a negative real return of approximately -1.92%. This means that the $10,200 she now possesses can purchase roughly 1.92% fewer goods and services than her initial $10,000 could at the beginning of the year. This illustrates how inflation can silently erode wealth, even when an investment appears to be growing.

Practical Applications

Negative real returns have significant practical applications across various financial domains:

• Personal Finance and Savings: For individuals, consistently experiencing a negative real return on savings accounts or low-yielding investments means their future purchasing power is diminishing. This underscores the importance of seeking investment options that at least match, if not exceed, the rate of inflation.
• Retirement Planning: Retirees relying on fixed incomes or pension payments are particularly vulnerable. If their income does not adjust with inflation, their ability to cover living expenses erodes over time, necessitating careful asset allocation that considers real returns.
• Bond Market Analysis: Conventional bonds, which pay a fixed coupon, are highly susceptible to negative real returns during inflationary periods. Investors in the fixed income market must consider inflation-protected securities, such as Treasury Inflation-Protected Securities (TIPS), which are designed to adjust their principal value based on inflation. The U.S. Department of the Treasury offers TIPS to help investors protect against inflation.⁶
• Monetary Policy and Central Banks: Central banks, like the Federal Reserve in the United States, aim to maintain price stability, often targeting a specific inflation rate.⁵ Persistently high inflation that leads to widespread negative real returns can prompt central banks to implement tighter monetary policy, such as raising interest rates, to combat rising prices.⁴
• Investment Portfolio Management: Professional portfolio managers constantly assess the potential for negative real returns across different asset classes. They may adjust diversification strategies to include assets that historically exhibit better performance during inflationary cycles, or employ risk management techniques to mitigate the impact.³

Limitations and Criticisms

While the concept of negative real return is crucial for understanding the true erosion of wealth due to inflation, it also has certain limitations and criticisms.

One limitation stems from the measurement of inflation itself. The most commonly used measure, the Consumer Price Index (CPI), reflects a "basket" of goods and services consumed by the average urban consumer. However, an individual's personal inflation rate may differ significantly based on their specific spending habits. For example, if an individual's primary expenses (like housing or healthcare) are rising faster than the overall CPI, their personal real return could be even more negative than the standard calculation suggests.

Another criticism relates to the practical ability of investors to consistently avoid negative real returns, especially in certain market conditions. During periods of aggressive central bank easing or significant economic uncertainty, nominal interest rates might be intentionally kept very low, making it difficult for even "safe" investments like savings accounts or short-term bonds to keep pace with inflation. This can force investors to take on more investment risk in pursuit of positive real returns, potentially leading to unintended consequences in their portfolio management strategies. Research has also indicated that equity markets tend to underperform when inflation is relatively high, presenting a challenge for investors seeking positive real returns through stock investments during such times.²,¹

Furthermore, the calculation of a negative real return often relies on historical inflation data, which may not be a perfect predictor of future inflation. This forward-looking uncertainty adds complexity to investment decisions aimed at protecting real wealth, making it a continuous challenge to preserve purchasing power.

Negative Real Return vs. Nominal Return

The distinction between a negative real return and a nominal return is fundamental in finance. A nominal return is simply the stated return on an investment or the observed gain in an asset's value, expressed as a percentage, without any adjustment for inflation. For instance, if a stock rises from $100 to $105, its nominal return is 5%.

A negative real return, however, delves deeper into the actual economic impact of that nominal gain by factoring in the rate of inflation. It represents a situation where the nominal return is insufficient to offset the rise in the cost of living. While the nominal return might be positive (e.g., 5% gain on a stock), if the inflation rate is higher (e.g., 7%), the investment's negative real return means that the investor's money can buy less than before. The confusion often arises because the numerical value of an investment may increase, giving the illusion of growth, even as the true value of that money declines. Understanding the difference is crucial for accurately assessing wealth accumulation and preserving purchasing power over time, particularly given the long-term effects of compounding.

FAQs

What causes a negative real return?

A negative real return is primarily caused by an inflation rate that exceeds the nominal return of an investment. This often happens when interest rates on savings accounts or bonds are lower than the inflation rate, or when investments perform poorly relative to rising prices.

How does inflation impact my investments?

Inflation erodes the purchasing power of money over time. If your investment returns do not keep pace with inflation, the real value of your investments decreases, meaning you can buy less with your money in the future.

Can I avoid a negative real return?

While it can be challenging, especially during periods of high inflation, investors can aim to mitigate the risk of negative real returns. Strategies include investing in inflation-indexed securities like Treasury Inflation-Protected Securities (TIPS), considering assets that have historically performed well during inflationary periods (such as real estate or commodities), or diversifying a portfolio across various asset classes.

Is a negative real return always bad?

For an individual investor, a sustained negative real return on their assets is generally detrimental as it means their wealth is losing value in real terms. However, temporary periods of negative real returns, particularly for short-term, highly liquid assets, may be an acceptable trade-off for safety and accessibility. The long-term goal for most investors is to achieve positive real returns to grow or preserve wealth.