Real rate of return

Before you rely on it

What to check

Subtract inflation over the same period as the return, not a long-run average.

The common error

Where people go wrong with real rate of return

Celebrating a nominal number in a high-inflation year. The account grew and the standard of living it supports did not, and only one of those is the point.

Worked through

Real rate of return in plain numbers

An investment earns 7% nominal in a year when prices rise 3%. The quick approximation subtracts, giving 4%. The exact real return is (1.07 ÷ 1.03) − 1, which is 3.88%, and the gap is small at these levels and grows when inflation is high. Now compound it. $10,000 growing at 7% for 30 years becomes about $76,123 in future dollars. At 3% inflation those dollars buy what about $31,360 buys today; the real return of 3.88% grows $10,000 to about $31,360 in today's purchasing power. It is the measure that says how much richer you actually became.

Easily confused

Real rate of return and its neighbours

The real return is not the nominal return, though both come from the same investment. Nominal is the number reported, before adjusting for price changes. Real strips out inflation, showing change in purchasing power. After-tax return removes taxes. Real return can be negative even when nominal is positive, and it also differs from the real interest rate on a loan, which is the nominal rate minus expected inflation, and is a similar idea; many planners assume a real return in long projections to avoid guessing future inflation.

In real decisions

Where real rate of return turns up

Retirement planners use real returns to project savings in today's dollars. Investors compare assets by real return over long periods. Savers see whether a bank rate beats inflation. Inflation-protected bonds pay a stated real yield. Policymakers watch real interest rates. When you evaluate a long goal, working in real terms keeps the units consistent and avoids being fooled by rising numbers that buy less.

Know the edges

Where real rate of return stops being reliable

Inflation is measured by an index that may not match your own costs, and future inflation is uncertain. Returns vary from year to year. Taxes and fees reduce real results further. Historical averages do not guarantee future results. Treat any projection as a scenario and test more than one.

Quick answers

What people ask about real rate of return

How do I calculate it exactly? Divide one plus the nominal return by one plus inflation, and subtract one. For 7% and 3%, that is 1.07 ÷ 1.03 − 1, or 3.88%.

Why do planners prefer real returns? They keep projections in today's purchasing power, so you do not need to guess future prices separately.

Can the real return be negative? Yes, whenever inflation exceeds your nominal return. Cash held at low interest during high inflation loses buying power.

What is the Fisher equation? It relates nominal, real and inflation rates. Approximately, real equals nominal minus inflation, and exactly, one plus nominal equals one plus real times one plus inflation.

How do I find the real return on a bond? Subtract expected inflation from the yield, or use an inflation-linked bond, whose stated yield is already real.