Real return is the actual amount of money an investor earns on an investment, taking into account fees, dividends, and commissions. Nominal return is the stated percentage an investor will earn, but it does not consider inflation. To calculate the real rate of return, subtract external factors from the nominal rate of return. Understanding real return is important for investors to determine the actual purchasing power of their investments.
Real return, also called the real rate of return, refers to the amount of money an investor actually makes on his investment. It is the amount paid by an investment, net of fees, dividends and commissions. By evaluating the real return, an investor can determine how much he is actually earning on an investment to determine whether the investment is a good deal or a bad deal.
Many investments are presented in terms of nominal rate of return. The nominal rate of return is the stated percentage an investor will earn. For example, if an investor opens a bank account or purchases a certificate of deposit (CD), he or she is told the interest rate the investment will pay. The bank may say that the account pays five percent interest.
This quoted interest figure is the nominal rate of return. It does not take into account inflation. It is simply the total interest amount paid on the investment.
If inflation is three percent, however, the actual amount of interest an investor earns is less than five percent. Three percent of that interest cost is simply covered by inflation. The real rate of return on the investment, therefore, is actually only two percent.
Understanding true return is essential to understanding the return on an investment and to understanding how much money the investment will generate for an investor. If an investor wants to retire, for example, he will be primarily concerned with how much his investments will give him a living. So he worries about the amount of purchasing power his dollar interests will buy.
To determine the purchasing power he will have if he tries to live off the interest on his investments, he must know the real return. Assuming that you earn five percent a year on an investment with a nominal return of five percent a year would be a grave mistake. Since the purchasing power of a dollar would drop by three percent with an inflation rate of three percent, it would actually live on only two percent instead of the five percent it expected.
Calculating the real yield is simple. Determine any external factors that add to the value of a dollar saved. Then, subtract those external factors from the nominal rate of return to find out what the real rate of return will be.
Smart Assets.
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