Nominal return",

What Is Nominal Return?

Nominal return is the total percentage an investment gains over a specific period, before accounting for factors like inflation, taxes, or fees. It represents the raw, unadjusted growth of an investment's value. This concept is fundamental within the broader category of investment performance measurement, providing a straightforward view of how much money an asset has generated. While a positive nominal return indicates an increase in the numerical value of an investment, it doesn't necessarily mean an increase in purchasing power.

History and Origin

The concept of distinguishing between nominal and real values in economics and finance gained prominence as economists deepened their understanding of inflation's impact. Irving Fisher, a prominent American economist, extensively explored the relationship between interest rates and inflation in the early 20th century, particularly through his "Fisher Equation." This work highlighted that nominal interest rates (and by extension, nominal returns) include an inflation premium to compensate lenders for the erosion of purchasing power. The Federal Reserve Bank of San Francisco notes that economists often focus on "core inflation," which excludes volatile energy and food prices, for a more accurate understanding of underlying price trends⁶. The U.S. Bureau of Labor Statistics, through its Consumer Price Index (CPI), officially measures inflation, providing a key benchmark for adjusting nominal figures to real terms. The CPI measures changes in the prices paid by urban consumers for a representative basket of goods and services⁴, ⁵.

Key Takeaways

• Nominal return indicates the unadjusted percentage gain of an investment.
• It does not account for the eroding effects of inflation or other deductions like taxes and fees.
• A positive nominal return does not guarantee an increase in purchasing power.
• Understanding nominal return is crucial for calculating real return, which reflects the true growth in buying power.
• It serves as a starting point for evaluating investment performance before deeper analysis.

Formula and Calculation

The nominal return is calculated as the percentage change in an investment's value over a period.

The formula for nominal return is:

Where:

• Current Value of Investment is the value of the investment at the end of the period.
• Original Value of Investment is the value of the investment at the beginning of the period.

This calculation provides a simple percentage gain, prior to considerations such as compound interest or regular additions, which would factor into more complex return measures like time-weighted return.

Interpreting the Nominal Return

Interpreting the nominal return requires careful consideration of the prevailing economic environment, particularly inflation. A high nominal return might seem impressive at first glance, but its actual value to an investor depends on how much prices for goods and services have risen over the same period. For instance, if an investment yields a nominal return of 8% but inflation is 5%, the investor's real purchasing power has only increased by approximately 3%. This distinction is vital for understanding the true growth of capital and making informed financial decisions. Investors often compare nominal returns against a relevant benchmark index or the return of other asset classes to gauge relative performance.

Hypothetical Example

Suppose an investor buys 100 shares of a stock at $50 per share, for a total initial investment of $5,000. After one year, the stock price rises to $55 per share, and the investor also receives $100 in dividends.

To calculate the nominal return:

1. Calculate the ending value of the investment:

   • Shares value: 100 shares * $55/share = $5,500
   • Total ending value (including dividends): $5,500 + $100 = $5,600

2. Apply the nominal return formula:

   • Nominal Return = (\frac{($5,600 - $5,000)}{$5,000} \times 100%)
   • Nominal Return = (\frac{$600}{$5,000} \times 100%)
   • Nominal Return = (0.12 \times 100%)
   • Nominal Return = (12%)

In this hypothetical example, the nominal return on the investment is 12%. This figure shows the gross increase in the investment's value, without considering any changes in the cost of living.

Practical Applications

Nominal return is widely used across various financial applications, though often as a preliminary step before accounting for inflation.

• Investment Reporting: Brokerage firms and fund managers frequently report nominal returns for different timeframes, such as one-year, three-year, or five-year periods, to show the raw performance of mutual funds, exchange-traded funds (ETFs), and individual securities.
• Loan and Savings Rates: The interest rate quoted on a loan or a savings account is typically a nominal rate. For instance, a bank offering a 2% interest rate on a savings account is stating its nominal return³.
• Economic Indicators: When discussing economic growth, figures such as nominal GDP reflect the total value of goods and services produced at current prices, without adjusting for inflation. The International Monetary Fund (IMF) emphasizes that long-lasting periods of high inflation are often a result of lax monetary policy and that inflation can distort purchasing power over time².
• Financial Planning: While nominal returns are a starting point, financial planners typically convert them to real returns to properly assess future retirement income needs and the impact of inflation on long-term goals.

Limitations and Criticisms

Despite its simplicity, nominal return has significant limitations, primarily due to its failure to account for inflation. The most common criticism is that a positive nominal return can still result in a loss of purchasing power if the rate of inflation exceeds the nominal return. This phenomenon means that while the numerical value of an investment grows, the investor can buy fewer goods and services with that money. The Federal Reserve Bank of San Francisco highlights that unexpected inflation erodes the real value of savings and debt with fixed nominal interest rates, redistributing wealth from savers to borrowers¹.

Another limitation is that nominal return does not consider taxes or investment fees, which further reduce the actual amount an investor retains. For example, a 10% nominal return on an investment might become considerably less after a 2% expense ratio and capital gains taxes are applied. This lack of adjustment makes nominal return a less comprehensive measure for true wealth accumulation compared to post-tax, inflation-adjusted figures. Understanding these drawbacks is critical for investors to avoid the money illusion, where one perceives an increase in wealth based solely on nominal terms.

Nominal Return vs. Real Return

The key difference between nominal return and real return lies in their consideration of inflation.

While nominal return provides the raw growth figure, real return offers a more accurate picture of an investor's increased buying power. Financial professionals generally advise investors to focus on real returns for long-term financial planning, as it provides a clearer indication of how their wealth is truly growing in relation to the cost of goods and services.

FAQs

Why is nominal return important if it doesn't account for inflation?

Nominal return is important because it provides the raw, unadjusted growth of an investment's value. It's the starting point for calculating other, more refined return metrics like real return. It's what's typically reported by financial institutions.

How does inflation affect nominal return?

Inflation erodes the purchasing power of money. While nominal return shows the percentage increase in the monetary value of an investment, inflation reduces what that increased amount can actually buy. If nominal return is lower than the inflation rate, you experience a loss in real purchasing power.

Does nominal return include taxes and fees?

No, nominal return does not include taxes or fees. It represents the gross gain of the investment before any deductions. To understand the actual return after these deductions, you would need to calculate the net return.

Can an investment have a positive nominal return but a negative real return?

Yes, absolutely. This occurs when the nominal return percentage is less than the inflation rate over the same period. For example, if your investment yields a 5% nominal return but inflation is 7%, your real return is approximately -2%, meaning your purchasing power has decreased. This highlights the importance of understanding both types of returns.

What is the relationship between nominal return, real return, and inflation?

These three concepts are linked by the Fisher Equation, which states that the nominal interest rate is approximately equal to the real interest rate plus the inflation rate. Similarly, nominal return is approximately the sum of real return and the inflation rate. This relationship is critical for investors and economists to analyze the true performance of investments and the health of an economy.

Is nominal return used for bonds or stocks?

Nominal return is applicable to all types of investments, including stocks, bonds, real estate, and even savings accounts. For example, the stated yield on a bond is a nominal yield, and the percentage price appreciation of a stock before inflation is its nominal return.

Why do some financial reports only show nominal returns?

Financial reports often show nominal returns because they are simpler to calculate and present the unadjusted monetary growth. However, reputable reports will usually clarify that these are nominal figures and encourage investors to consider the impact of inflation. Sometimes, depending on the regulatory requirements, performance reporting standards may dictate the primary display of nominal returns.