Real vs Nominal Returns: What's the Difference?

Investment returns are often expressed as percentages. However, a return percentage does not always show how much an investor's purchasing power has changed.

This is where the distinction between nominal returns and real returns becomes useful. Nominal returns show the change in the value of an investment before considering inflation, while real returns attempt to account for the effect of changes in purchasing power.

What Is a Nominal Return?

A nominal return is the percentage gain or loss on an investment without adjusting for inflation.

For example, imagine an investment increases in value from ₹100,000 to ₹108,000 over one year. Ignoring taxes, fees and other factors, the nominal return would be 8%.

The nominal return tells you how the value of the investment changed in money terms. It does not, by itself, indicate whether the increased amount can buy more goods and services than before.

What Is a Real Return?

A real return adjusts the investment outcome for the effect of inflation. It provides a way to think about how an investment's return may have affected purchasing power.

If prices rise during the same period in which an investment generates a return, part of the nominal gain may be offset by the reduction in purchasing power caused by inflation.

A Simple Example

Suppose an investment generates a nominal return of 8% during a period when inflation is approximately 5%.

A simple approximation might suggest that the real return is around 3%. However, the exact calculation uses a relationship between the investment return and inflation rather than simply subtracting one percentage from the other.

This example is simplified and does not include taxes, investment costs, fees or changes in an individual's specific expenses.

How Real Return Can Be Calculated

A commonly used relationship for calculating an inflation-adjusted return is:

For example, if a nominal return is 8% and inflation is 5%:

((1.08 ÷ 1.05) − 1) × 100 ≈ 2.86%

This demonstrates why simply subtracting inflation from the nominal return can provide an approximation but may not produce the exact inflation-adjusted result.

Why Inflation Matters

Inflation can affect the purchasing power of money. If the prices of goods and services rise, a certain amount of money may buy fewer goods or services than before.

For long-term financial goals, this can be important because the future cost of a goal may be higher than its current cost.

Examples may include:

• Retirement expenses
• Education costs
• Housing expenses
• Healthcare expenses
• Everyday living costs

Nominal Returns Can Still Be Useful

Nominal returns remain useful because investment performance is often reported in nominal terms. They show the actual percentage increase or decrease in the value of an investment over a specific period.

However, comparing nominal returns with changes in inflation can provide additional context when evaluating long-term purchasing power.

Real Returns and Long-Term Investing

For long-term investors, purchasing power can be an important consideration. A portfolio may increase in nominal value while inflation simultaneously increases the future cost of goods and services.

This does not mean that every investment must outperform inflation every year. Investment returns can fluctuate, and inflation rates can also change over time.

Instead, understanding real returns can help investors think about the difference between the growth of an investment's value and changes in the cost of living.

Other Factors That Can Affect Actual Returns

Inflation is only one factor. The amount an investor actually keeps or can use may also be affected by:

• Investment fees and expenses
• Taxes
• Transaction costs
• Investment losses
• Timing of investments and withdrawals
• Changes in personal spending needs

Because these factors can vary, an individual's actual financial outcome may differ from a simple nominal or real return calculation.

Real Return Does Not Guarantee Future Purchasing Power

Calculating a historical real return does not guarantee that the same result will occur in the future. Inflation, market performance, investment costs and other factors can change.

Investment values can rise or fall, and investors may receive back less than they originally invested.

Key Differences Between Real and Nominal Returns

• Nominal return: Measures investment gains or losses without adjusting for inflation.
• Real return: Adjusts the return to consider the effect of inflation.
• Nominal return focuses on changes in monetary value.
• Real return focuses more on changes in purchasing power.
• The difference between the two can become important when evaluating long-term financial goals.

Key Takeaways

• Nominal returns do not account for inflation.
• Real returns attempt to show returns after considering inflation.
• Inflation can reduce the purchasing power of money over time.
• A positive nominal return does not automatically mean purchasing power increased.
• Fees, taxes and other costs can also affect actual investment outcomes.
• Investment returns are uncertain and cannot be guaranteed.

Final Thoughts

Understanding the difference between real and nominal returns can help provide additional context when evaluating investment performance and long-term financial goals.

Nominal returns show how investment values changed, while real returns provide a way to consider how inflation may affect the purchasing power of those gains or losses. Both concepts can be useful when reviewing financial decisions over time.