Real

What Is Real Return?

Real return represents the actual increase or decrease in an investment's purchasing power after accounting for the effects of inflation. It is a critical metric within investment performance analysis, providing a more accurate picture of an investor's true gains or losses over time. While a high nominal return might appear attractive, it can be misleading if the cost of living has risen significantly during the same period. Understanding real return is essential for long-term financial planning, as it directly reflects changes in an investor's purchasing power.

History and Origin

The concept of distinguishing between nominal and real values in economics and finance has roots in early monetary theory, as economists grappled with how changes in the money supply and prices affected wealth. The importance of adjusting financial figures for inflation became particularly evident during periods of significant price instability. For instance, the high inflation rates experienced in the 1970s underscored the necessity for investors to consider the erosion of their returns by rising prices. Measures like the Personal Consumption Expenditures (PCE) price index, which is the Federal Reserve's preferred gauge of inflation, help to quantify this erosion and allow for the calculation of real returns.⁵ Academic research has consistently highlighted the distinction, with studies delving into long-run asset returns emphasizing that nominal figures often overstate actual wealth accumulation when inflation is present.⁴

Key Takeaways

• Real return measures an investment's gain or loss after adjusting for inflation, reflecting changes in purchasing power.
• It provides a more accurate assessment of investment performance compared to nominal returns.
• Calculating real return is crucial for long-term financial planning, such as retirement savings.
• Inflation can significantly erode nominal gains, potentially leading to a negative real return even if the nominal return is positive.
• Investors consider real return to ensure their portfolios are growing sufficiently to meet future financial goals.

Formula and Calculation

The real return can be calculated using the Fisher Equation, or a simpler approximation for smaller inflation rates.

The precise formula, known as the Fisher Equation, is:

$\text{Real Return} = \frac{(1 + \text{Nominal Return})}{(1 + \text{Inflation Rate})} - 1$

Where:

• Nominal Return: The stated percentage return on an investment before adjusting for inflation, encompassing capital gains and dividends, or interest rate earned.
• Inflation Rate: The rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. This is often measured by indices like the Consumer Price Index (CPI) or the PCE price index.

For simpler, approximate calculations, especially when inflation is low, the following formula is often used:

$\text{Real Return} \approx \text{Nominal Return} - \text{Inflation Rate}$

This approximation can be less accurate during periods of high inflation.

Interpreting the Real Return

Interpreting real return involves comparing it to zero and to your financial goals. A positive real return indicates that your investment has grown more than the rate of inflation, meaning your purchasing power has increased. Conversely, a negative real return signifies that inflation has outpaced your investment gains, leading to a decrease in your actual buying power. For example, if an investment yields a 5% nominal return, but inflation is 3%, the real return is approximately 2%, meaning your money can buy 2% more goods and services. However, if inflation is 7%, your real return is -2%, indicating a loss of purchasing power despite a positive nominal gain. Investors must aim for positive real returns to achieve long-term wealth accumulation and to preserve their financial well-being against the eroding effects of economic growth and rising prices.

Hypothetical Example

Consider an investor, Sarah, who purchased a mutual fund. Over the past year, her fund generated a nominal return of 8%. During the same period, the rate of inflation, as measured by the PCE price index, was 3%.

To calculate her real return, Sarah would use the formula:

$\text{Real Return} = \frac{(1 + 0.08)}{(1 + 0.03)} - 1$
$\text{Real Return} = \frac{1.08}{1.03} - 1$
$\text{Real Return} = 1.0485 - 1$
$\text{Real Return} = 0.0485 \text{ or } 4.85\%$

In this scenario, while Sarah's fund saw an 8% increase in its dollar value, her actual purchasing power only increased by 4.85%. This example highlights that focusing solely on nominal gains can obscure the true growth of an investment in real terms. It helps Sarah understand if her asset allocation strategy is effectively combating inflation.

Practical Applications

Real return is a fundamental concept across various financial domains. In portfolio theory, it guides investors in selecting assets that can not only generate nominal gains but also protect and grow purchasing power over time. For long-term financial planning, such as retirement savings or funding education, understanding real return is paramount. Investors utilize this metric to set realistic growth expectations and adjust their diversification strategies to combat inflation. For instance, historically, equities have tended to offer better real returns over the long run compared to other asset classes, but this can vary depending on economic cycles and market volatility.³ Without considering real return, an investment might seem successful on paper, but it could actually be losing value in terms of what it can buy. The impact of inflation on investments is a widely studied area, underscoring the necessity of calculating real returns to ensure that financial goals are met.

Limitations and Criticisms

While real return offers a crucial perspective on investment performance, it has certain limitations. One primary criticism is its reliance on accurate inflation data. Different inflation measures, such as the Consumer Price Index (CPI) versus the Personal Consumption Expenditures (PCE) price index, can yield varying real return figures. The choice of inflation index can significantly impact the perceived real return, and these indices may not perfectly reflect an individual's personal inflation rate. Furthermore, past real returns are not indicative of future results, and sustained positive real returns are never guaranteed due to various market and economic factors. Periods of high inflation or unexpected economic shocks can severely impact real returns, making long-term projections challenging.² Investors should be aware that even a historically strong asset class like the S&P 500, which has demonstrated an average annual real return, experiences fluctuations and periods of significant downturns. Investors often make behavioral errors, which means their actual dollar-weighted returns can be lower than reported buy-and-hold returns, a phenomenon that can further erode real gains.¹

Real Return vs. Nominal Return

Real return and nominal return are both measures of investment performance, but they differ fundamentally in how they account for inflation.

The key distinction lies in the concept of purchasing power. Nominal return simply tells you how much your money has grown in absolute dollar terms. For instance, if you invest $100 and it grows to $110, your nominal return is 10%. However, if the cost of goods and services also increased by 5% during that time, your $110 can buy less than it could if prices had remained stable. Real return, by factoring in inflation, provides a more realistic assessment of what your investment can actually buy. Therefore, while nominal return is easier to calculate, real return is generally considered more meaningful for assessing long-term financial success and evaluating investment strategies, especially when considering the impact of compounding over many years.

FAQs

Why is real return important for investors?

Real return is important because it indicates whether your investments are truly increasing your wealth by outpacing the rate at which prices are rising. Without considering real return, you might mistakenly believe your portfolio is growing, when in reality, your money's buying power could be shrinking due to inflation. This metric helps investors preserve and grow their risk-free rate adjusted capital.

How does inflation affect real return?

Inflation directly reduces real return. If an investment's nominal return is less than the inflation rate, the real return will be negative, meaning your investment is losing purchasing power. Even if the nominal return is positive, high inflation can significantly diminish the real gain, eroding the actual value of your savings and investments over time.

Can real return be negative?

Yes, real return can be negative. This occurs when the nominal return on an investment is lower than the rate of inflation. For example, if your investment earns 2% but inflation is 4%, your real return is -2%, indicating a loss of purchasing power.

What assets tend to have higher real returns over the long term?

Historically, growth-oriented assets like equities (stocks) have tended to provide higher real returns over the long term compared to fixed-income investments like bonds or cash. However, past performance is not indicative of future results, and all investments carry inherent risks. Diverse portfolios incorporating various asset classes are often recommended to manage risk-adjusted return and target real returns.

How can I protect my investments from inflation's impact on real return?

Protecting investments from inflation's impact on real return involves strategic asset allocation. This can include investing in assets that historically perform well during inflationary periods, such as real estate, commodities, or inflation-protected securities. Diversifying across various asset classes and regularly reviewing your portfolio's performance against inflation are key strategies.