What it means
When you invest money, you want to know what you earned. The simplest answer is the nominal return, which compares the value at the end with the amount invested at the start.
If $10,000 grows to $10,800, the nominal return is 8%. This figure is useful because it matches what appears on statements and what the tax authority usually sees.
Fund factsheets, savings account rates and bond yields are normally quoted in nominal terms. It is also the easiest to calculate, requiring only the starting and ending values plus any income received.
The weakness is that it ignores inflation. If prices rise by 3% in the same period, your 8% nominal gain buys less than it appears to.
The real return, which adjusts for that, is the measure that shows the true increase in purchasing power. Taxes and fees can also reduce what you keep.
A nominal return quoted before fees might fall noticeably after a management charge of 1% is deducted. When comparing options, check whether the quoted return is before or after costs, so you compare like with like.
In business, nominal returns are used to set targets, such as a required return on a project. Many companies set the required rate in nominal terms and then compare projects' cash flows measured in nominal dollars.
The key rule is consistency: nominal cash flows should be discounted at nominal rates and real cash flows at real rates. There is also a variant to be aware of.
Nominal can refer to a rate that does not account for compounding, such as a stated annual rate with monthly interest. The effective rate, which includes compounding, will be slightly higher.
In practice
Real-world examples.
Example
A company invests $500,000 of spare cash in a short-term bond fund. After a year the investment is worth $525,000. The nominal return is 25,000 / 500,000 = 5%, and the treasurer reports it as such. Inflation was 3% over the same year, so the real return was under 2%.
Example
A saver earns 4% on a savings account, but prices rise by 4% in the same year. The nominal return is 4%, while the real return is zero. She decides to look for an account or investment that has a chance to beat inflation. She reads the fine print to see whether the quoted rate is before or after tax.
Example
A property investor buys a flat for $300,000 and sells it a year later for $321,000, also collecting $9,000 in rent. The nominal return is (321,000 - 300,000 + 9,000) / 300,000 = 10%. He compares it with the mortgage cost and local inflation before deciding whether to buy again. Rent was a large part of the gain, so he checks that it is likely to continue.
Formula
Calculation
Nominal rate of return = (ending value - starting value + income received) / starting value x 100
Real rate of return = (1 + nominal rate) / (1 + inflation rate) - 1
An investor puts $10,000 into a fund, which grows to $10,800 with no income received. Nominal return = (10,800 - 10,000) / 10,000 = 8%. If inflation is 2%, real return = 1.08 / 1.02 - 1 = 0.0588, or about 5.88%.Case study
Seen in the real world.
Redwood Pension Services is a fictional adviser that reviewed a client's portfolio of $400,000. In this illustrative story, the portfolio had grown to $432,000 over a year, a nominal return of 8%. The client was delighted and wanted to move into riskier investments to chase higher gains.
The adviser pointed out that inflation had run at 6% during the same year, so the real return was 1.08 / 1.06 - 1 = about 1.89%. After the adviser's fee of 1% of the portfolio, or $4,320, the client's gain in purchasing power was under 1%. The client agreed to keep the existing mix of investments and asked for quarterly reports showing both nominal and real figures.
The adviser prepared a one-page summary for the client showing the nominal return, inflation, the fee and the real return side by side. The client said it was the first time the figures had been laid out so plainly. The summary became a standard part of the firm's annual review.
Watch out
Common mistakes.
- Treating the nominal rate as the true gain in wealth. Inflation, taxes and fees all reduce what you can actually buy.
- Comparing nominal returns across different countries or periods. High-inflation economies often show larger nominal figures that hide weak real returns.
- Forgetting income. Interest and dividends belong in the calculation along with the change in price.
Questions
People also ask.
What is the difference between nominal and real return?
The nominal return ignores inflation, while the real return adjusts for it.
Is the nominal rate of return the same as the interest rate?
For a simple deposit it is similar, but for an investment it also includes price changes and income.
Which one should I use to make decisions?
Use the real rate to judge your gain in purchasing power, and the nominal rate to see the cash you will receive.
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