What it means
Investors quote returns in nominal terms because that is what the statement shows, but nominal returns from different periods are not comparable with each other. Converting to a real return puts every year on the same footing by measuring the gain in purchasing power rather than the gain in dollars.
It matters most for anything with a long horizon: pensions, endowments, sinking funds and corporate reserves. Compounding at 4% real for thirty years leaves a fund about 79% larger than compounding at 2%, so the adjustment is far from a technicality.
The precise calculation divides rather than subtracts, following the same Fisher relationship used for interest rates. Subtracting inflation from the nominal return is a fair approximation when both numbers are small, but it overstates the real return once inflation is high.
Serious comparisons go one step further and deduct tax and fees before the inflation adjustment, because tax is charged on the nominal gain rather than the real one. In a high inflation year an investor can end up paying tax on a gain that, measured in purchasing power, never happened.
Different assets behave differently against inflation, which is the practical reason the measure exists. Cash deposits usually deliver a small or negative real return, index-linked bonds are designed to deliver a stated real return, and equities and property have historically produced a positive real return over long periods while swinging widely along the way.
In practice
Real-world examples.
Example
A pension scheme reports a 7% return and the trustees are pleased, until the actuary notes that its liabilities are linked to prices, which rose 6% that year. The real return of about 0.9% barely moved the funding position at all.
Example
A manufacturer can put $1,500,000 on deposit at 4% or spend it on an automated line expected to return 11% in nominal terms. With inflation at 4%, the deposit's real return is roughly zero while the project's is about 6.7%, which settles a board argument that had run for months.
Example
A landlord sees a flat rise in value from $320,000 to $416,000 over five years, a nominal gain of 30%. Cumulative inflation across the same five years was 22%, so the real gain is about 6.6%, well short of the headline figure.
Formula
Calculation
Real Rate of Return = (1 + Nominal return) / (1 + Inflation rate) - 1
A portfolio worth $250,000 at the start of the year is worth $272,500 at the end, a nominal return of $22,500 / $250,000 = 9%. Inflation over the year was 3.5%. The real return is 1.09 / 1.035 - 1 = 0.0531, or 5.31%. Checking that in dollars, the $272,500 restated in start-of-year money is $272,500 / 1.035 = $263,285.02, a real gain of $13,285.02 on $250,000, which is the same 5.31%. If the $22,500 gain is taxed at 20%, the after-tax nominal return falls to $18,000 / $250,000 = 7.2%, and the after-tax real return becomes 1.072 / 1.035 - 1 = 0.0357, or 3.57%.Case study
Seen in the real world.
The Wren Foundation is a fictional charitable endowment, described here as an illustrative example. It held $40,000,000 and had a policy of spending 4.5% of the fund each year on grants, on the assumption that investment returns would comfortably replace what was spent.
Over the following decade the portfolio returned an average of 7.2% a year in nominal terms, which the board reported as a strong result. Inflation averaged 3.4%, so the real return was 1.072 / 1.034 - 1, or about 3.7% a year, which was less than the 4.5% being spent. The purchasing power of the endowment therefore fell by roughly 0.8% a year, and after ten years the $40,000,000 was worth about $36,900,000 in the money of the starting year, a decline of nearly 8%.
The trustees changed two things. Spending was reset to a rolling percentage of the average fund value rather than a fixed rate, and every performance report from then on showed nominal return, inflation and real return together, so the gap could never again hide inside a good-looking headline number.
Watch out
Common mistakes.
- Comparing returns from different decades without adjusting for inflation. An 11% return in a high inflation period can be worth less in real terms than a 5% return in a low inflation one.
- Applying tax after the inflation adjustment. Tax is charged on the nominal gain, so it must be deducted from the nominal return before inflation is stripped out, otherwise the real result is overstated.
- Assuming a positive nominal return always protects capital. If inflation exceeds the return, the investor is poorer at the end of the year despite a larger balance.
Questions
People also ask.
Is the real rate of return the same as the real interest rate?
They use the same calculation, but the real interest rate applies to borrowing and lending while the real rate of return applies to any investment, including shares and property.
What is a reasonable long-run real return to plan on?
Long-term investors commonly plan around low single digits after inflation for a mixed portfolio, and treat anything materially higher as an assumption that needs justifying.
Why do index-linked bonds quote a real yield?
Because their payments already rise with a price index, so the only meaningful figure left to quote is the return above inflation.
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