Why real return matters
Nominal returns measure how your balance changes. Real returns measure how your purchasing power changes after inflation. Over long horizons, the difference can be huge.
Core relationship
Real return ~ (1 + nominal) / (1 + inflation) - 1.
Worked example (quick)
- Nominal return: 10% means $100 becomes $110.
- Inflation: 3% means prices rise so $100 of goods now costs $103.
- Real return compares purchasing power: 110/103 - 1 ~= 6.8%.
When the approximation is good enough
For small rates, a common shortcut is real ~= nominal - inflation. It is close when both rates are low, but the exact formula is better for high inflation or long horizons.
Taxes and fees matter for real outcomes
- After-tax real return can be much lower if taxes apply to nominal gains (not inflation-adjusted gains).
- Fees compound too; a 1% fee reduces long-run purchasing power materially.
- For cash, inflation is the 'fee' you always pay even when nominal return is zero.
Common use cases
- Retirement planning: translate portfolio growth into future buying power.
- Comparing periods: high nominal returns in a high-inflation era can be less impressive in real terms.
- Evaluating loans: compare nominal interest rates to expected inflation to understand real cost of borrowing.
Common mistakes
- Comparing nominal returns across periods with different inflation regimes.
- Using CPI inflation as a precise measure for personal spending baskets.
- Ignoring taxes (after-tax real return can be materially lower).
- Mixing real and nominal assumptions in a model (discount rate and cash flows must match).