Real return

What Is Real Return?

Real return represents the actual percentage of profit earned on an investment after accounting for the effects of inflation. It is a critical metric within the broader category of investment performance, offering a clearer picture of an investor's true gain in purchasing power over time. Unlike a nominal return, which states the raw percentage gain or loss, the real return adjusts for the erosion of money's value due to rising prices, providing a more accurate assessment of financial growth. Understanding real return is fundamental for assessing the effectiveness of an investment strategy and maintaining wealth.

History and Origin

The concept of distinguishing between nominal and real values in economic analysis has roots that stretch back centuries, with early economists grappling with how changes in the money supply and prices affected wealth. As formalized economic thought developed, particularly with the rise of modern macroeconomics, the impact of inflation on investment returns became increasingly apparent. The late 19th and early 20th centuries saw economists like Irving Fisher extensively analyze the relationship between interest rates and inflation, laying the groundwork for the modern understanding of real returns. Fisher's work helped to solidify the idea that the true cost of borrowing and the true return on lending are those adjusted for changes in the price level.

The periods of high inflation, such as the late 1970s and early 1980s, brought the importance of real return into sharp focus for investors and policymakers alike. During these times, seemingly high nominal interest rates on savings accounts could still result in a loss of purchasing power once inflation was factored in. This phenomenon underscored why inflation is sometimes referred to as "the silent tax" on financial assets.¹¹ The persistent rise in prices meant that the advertised returns were not the "real" returns received by individuals.

Key Takeaways

• Real return measures an investment's gain or loss after adjusting for inflation, reflecting actual purchasing power.
• It provides a more accurate assessment of investment performance compared to nominal return.
• Inflation significantly erodes the value of nominal returns, making real return crucial for long-term financial planning.
• Factors like taxes and investment fees also reduce the real return, further impacting an investor's true gains.
• Negative real returns indicate a loss of purchasing power, even if the nominal return is positive.

Formula and Calculation

The most common method for calculating real return, often referred to as the Fisher Equation approximation, subtracts the inflation rate from the nominal return.

The formula for approximating the real return is:

A more precise formula, especially useful when dealing with higher rates of return or inflation, is:

Where:

• Nominal Return: The stated percentage gain or loss on an investment over a period, without accounting for inflation.
• 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 commonly measured by the Consumer Price Index (CPI).¹⁰

For example, if an investment yields a nominal return of 8% and the inflation rate is 3%, the real return would be approximately 5% using the simplified formula, or ( (1 + 0.08) / (1 + 0.03) - 1 \approx 0.0485 ), or 4.85%, using the precise formula.

Interpreting the Real Return

Interpreting the real return is essential for understanding the true growth of wealth. A positive real return indicates that an investment has increased your purchasing power, meaning you can buy more goods and services with your money after accounting for rising prices. Conversely, a negative real return signifies that your investment's growth did not keep pace with inflation, leading to a decrease in your actual purchasing power, even if the nominal return was positive. This scenario is particularly detrimental for long-term financial planning and saving.

For instance, if your savings account offers a 2% interest rate (nominal return) but inflation is running at 4%, your money is effectively losing 2% of its purchasing power each year, resulting in a negative real return.⁹ Financial professionals often emphasize focusing on real returns when evaluating different asset classes and investment vehicles, as it provides a more realistic measure of wealth accumulation.

Hypothetical Example

Consider an investor who placed $10,000 in a certificate of deposit (CD) that offered an annual nominal interest rate of 5%. Over the same year, the Consumer Price Index (CPI) indicated an inflation rate of 3.5%.

To calculate the real return on this investment:

1. Identify the Nominal Return: 5% or 0.05
2. Identify the Inflation Rate: 3.5% or 0.035
3. Apply the formula:
   ( \text{Real Return} = \frac{(1 + 0.05)}{(1 + 0.035)} - 1 )
   ( \text{Real Return} = \frac{1.05}{1.035} - 1 )
   ( \text{Real Return} \approx 1.01449 - 1 )
   ( \text{Real Return} \approx 0.01449 )

The real return for this CD in the hypothetical example is approximately 1.45%. This means that while the investor's money grew by 5% nominally, its actual purchasing power only increased by about 1.45% due to the impact of inflation. This figure is what truly reflects the increase in the investor's ability to buy goods and services.

Practical Applications

Real return is a fundamental concept across various aspects of investing, markets, analysis, and financial planning. In portfolio management, investors use real return to evaluate the true performance of their holdings, especially for long-term goals like retirement planning. It helps in selecting appropriate asset classes that are likely to outpace inflation, such as equities or real estate, over extended periods.

For instance, Treasury Inflation-Protected Securities (TIPS) are government bonds specifically designed to protect investors from inflation by adjusting their principal value based on changes in the CPI, thereby guaranteeing a real rate of return. In economic analysis, central banks and policymakers monitor real interest rates to gauge the true cost of borrowing and the incentive for saving and investment in the economy. This perspective on real return helps them make informed decisions regarding monetary policy. For individual investors, understanding real return is crucial for achieving financial goals, as it directly impacts how much their savings can truly buy in the future. The U.S. Securities and Exchange Commission (SEC) provides resources to help investors understand the concept of real return and its implications.⁸

Limitations and Criticisms

While essential, real return calculations have certain limitations. One primary challenge is that the inflation rate used for adjustment is a backward-looking measure. The Consumer Price Index (CPI), commonly used to quantify inflation, is released with a delay and reflects past price changes.⁶, ⁷ Therefore, calculating a real return for a current or future period requires estimating or forecasting inflation, which introduces an element of uncertainty. This means that the "real" value of an investment is not definitively known until after the period has concluded and the official inflation data is available.

Furthermore, the CPI may not perfectly reflect the personal inflation experience of every individual. Spending patterns vary, and different households may face higher or lower price increases for the specific goods and services they consume. The calculation of real return also typically considers only inflation and the nominal return, sometimes overlooking other factors that erode actual wealth, such as capital gains taxes or investment fees.⁴, ⁵ For instance, an investment with a positive real return before taxes could become negative after accounting for tax liabilities on dividends or capital gains. These additional factors mean that the realized real return can be lower than the calculated real return adjusted only for inflation.

Real Return vs. Nominal Return

The distinction between real return and nominal return is fundamental in finance and investing. The nominal return is the stated or advertised percentage gain or loss on an investment over a period, without any adjustment for inflation. For example, if a stock increases in value by 10% in a year, its nominal return is 10%. This figure represents the absolute monetary increase in the investment's value.

In contrast, the real return adjusts the nominal return for the effects of inflation. It measures the true increase or decrease in an investor's purchasing power. The key difference lies in what each metric represents: nominal return shows how much money an investment has made in absolute terms, while real return shows how much an investor's actual buying power has changed.³ Except during rare periods of zero inflation or deflation, the nominal return will almost always be higher than the real return. Investors who solely focus on nominal returns risk underestimating the impact of inflation on their wealth, potentially leading to a gradual erosion of their purchasing power over time. Therefore, the real return offers a more accurate and meaningful measure of an investment's performance from a long-term wealth perspective.

FAQs

Why is real return important for investors?

Real return is crucial because it provides the most accurate measure of how an investment affects your true wealth. It tells you whether your money is actually growing in terms of what it can buy, rather than just in terms of its face value. This is especially important for long-term financial planning and saving for goals like retirement, where inflation can significantly erode purchasing power over decades.²

How does inflation affect real return?

Inflation directly reduces real return. As the general price level of goods and services rises, each dollar you hold or earn buys less. If your investment's nominal return does not exceed the inflation rate, your real return will be negative, meaning your money loses purchasing power. This erosion of value highlights the importance of seeking investments that can outpace inflation to preserve and grow wealth.

Can real return be negative?

Yes, real return can be negative. This occurs when the nominal return on an investment is less than the inflation rate. For example, if an investment yields a 3% nominal return but inflation is 5%, the real return is approximately -2%. A negative real return means that your investment has lost purchasing power, even if you have more money in absolute terms. Understanding this helps investors grasp the true risk to their purchasing power.

What are some ways investors try to achieve positive real returns?

Investors often seek positive real returns through diversification across various asset classes, such as stocks, real estate, and inflation-indexed bonds. Equities historically have shown the potential to deliver positive real returns over the long term, as corporate earnings and dividends can grow with inflation.¹ Investing in assets that have historically demonstrated a strong ability to keep pace with or exceed inflation is a key strategy for preserving and growing wealth in real terms.