Nominal total return

Nominal Total Return

Nominal total return represents the total percentage gain or loss on an investment over a specific period, measured in monetary terms, without accounting for the effects of inflation. It is a key metric within investment performance measurement, reflecting the absolute growth of an investment's value, including both price changes and any income generated. This figure is often the first measure investors encounter when reviewing their investment statements because it reflects the raw increase in the value of their holdings.

History and Origin

The concept of measuring investment returns has evolved with financial markets. Early forms of return calculation often focused solely on capital appreciation. However, as financial instruments diversified and income streams like dividends and interest became more significant components of overall investor gain, the need for a comprehensive "total return" metric emerged. The inclusion of income alongside capital gains in performance calculations became standard practice to provide a more accurate picture of an investment's actual profitability. Over time, the distinction between nominal returns (unadjusted for inflation) and real returns (inflation-adjusted) became crucial, particularly following periods of significant price increases, such as those experienced in the mid-20th century, which highlighted how inflation can erode purchasing power. The U.S. Bureau of Labor Statistics began publishing a national consumer price index (CPI) in 1921, with estimates back to 1913, providing a benchmark for measuring inflation.⁴,³

Key Takeaways

• Nominal total return measures the absolute percentage change in an investment's value, including both capital gains and income.
• It does not account for the impact of inflation, meaning it does not reflect the actual increase in an investor's purchasing power.
• This metric is widely used for initial reporting and comparison but can be misleading in environments with high or fluctuating inflation.
• Understanding nominal total return is foundational to grasping more nuanced performance metrics like real return.

Formula and Calculation

The nominal total return calculation includes both the change in the investment's market price (capital appreciation) and any income received, such as dividends for stocks or interest payments for fixed income securities.

The formula for nominal total return is:

Where:

• Ending Value: The market value of the investment at the end of the period.
• Beginning Value: The market value of the investment at the start of the period.
• Income Received: All cash distributions, such as dividends, interest, or other distributions, received from the investment during the period.

For example, if an equity share is bought for $100, pays a $2 dividend during the year, and is worth $105 at year-end, the nominal total return is calculated as:

Interpreting the Nominal Total Return

Nominal total return provides a straightforward measure of how much an investment has grown in monetary terms. A positive nominal total return indicates that the investment has increased in value, while a negative return signifies a loss. It is often the reported return on brokerage statements and is useful for comparing the performance of different investments over short periods when inflation might not be a primary concern. However, for long-term investors, relying solely on nominal total return can be deceptive. A high nominal return might still result in a diminished purchasing power if inflation rates are even higher. Investors should consider the context of the economic environment, particularly the prevailing inflation rate, when interpreting the significance of a nominal total return.

Hypothetical Example

Consider an investor who purchases a bond for $1,000. Over one year, the bond pays $50 in interest. At the end of the year, the bond's market value has increased to $1,020.

To calculate the nominal total return:

1. Identify the beginning value: $1,000
2. Identify the ending value: $1,020
3. Identify income received: $50 (interest)

Using the formula:

The nominal total return for this bond investment is 7%. This means the investor's capital has grown by 7% in dollar terms over the year. This calculation highlights the combination of capital appreciation and bond interest rate payments contributing to the overall return.

Practical Applications

Nominal total return is a fundamental metric used across various aspects of finance and investing. Portfolio managers use it to evaluate the performance of their portfolio against benchmarks over various periods. It is also routinely reported in fund fact sheets and annual reports, providing a clear, absolute measure of an investment's historical performance. For individual investors, understanding their nominal total return allows them to track the growth of their wealth and assess the effectiveness of their asset allocation decisions. For instance, the CFA Institute, a global association for investment professionals, discusses how total return for a portfolio encompasses changes in value and income distributions.² Furthermore, nominal total return is often the basis for calculating future values when modeling investment growth, assuming a constant rate of compounding.

Limitations and Criticisms

While straightforward, nominal total return has a significant limitation: it does not account for the erosion of purchasing power due to inflation. This means that a seemingly positive nominal return might not translate into an actual increase in an investor's ability to buy goods and services. For example, if an investment has a nominal total return of 5% in a year, but inflation for that same year is 3%, the investor's real gain in purchasing power is only about 2%. If inflation exceeds the nominal return, the investor experiences a loss in real terms, despite a positive nominal gain. This is a crucial consideration for long-term financial planning, particularly for goals like retirement, where maintaining purchasing power over decades is paramount. Financial institutions like the Federal Reserve Bank of San Francisco frequently publish research and data on inflation expectations, emphasizing the importance of understanding inflation's impact on real returns. High market volatility can also obscure the underlying performance trends when only nominal returns are considered over short periods.

Nominal Total Return vs. Real Return

The primary distinction between nominal total return and real return lies in the adjustment for inflation.

Nominal total return reflects the raw percentage increase in the monetary value of an investment. For example, if a bond yields 5% and the value increases by 2%, its nominal total return is 7%. However, if the annual inflation rate is 3%, the real return, which reflects the true increase in buying power, would be approximately 4%. Understanding this difference is critical for investors, as relying solely on nominal returns can lead to a false sense of security regarding wealth accumulation, especially during periods of high inflation. The Welch Group, a financial advisory firm, emphasizes that the real rate of return provides a clearer picture of how much wealth is actually growing after accounting for rising prices.¹

FAQs

What is the simplest way to think about nominal total return?

It is the total percentage gain or loss your investment makes in dollars, including any money you received from it (like dividends or interest), before considering how much prices have risen over time.

Why is nominal total return often reported on investment statements?

It's the most direct and easily calculable measure of an investment's raw financial performance. It shows the absolute increase or decrease in the monetary value of your holdings.

Does nominal total return tell me if I'm getting richer?

Not entirely. While a positive nominal total return means you have more money, it doesn't tell you if that money can buy more than it could before. To know if you're truly richer in terms of purchasing power, you need to consider inflation and look at the real return. A good example is a risk-free rate, which is typically a nominal return, but its real value depends on inflation.

Can nominal total return be negative?

Yes, if the capital losses and any income received do not offset the decline in the investment's price, the nominal total return will be negative. This means your investment lost monetary value over the period.