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Real return is the actual amount of money an investor earns on their investment, after fees, commissions, and dividends are adjusted. Nominal return is the stated percentage that an investor will make, but it does not take inflation into account. To determine the actual return, subtract external factors from the nominal rate of return.
Real return, also called the real rate of return, refers to the amount of money an investor actually earns on their investment. It is the amount an investment pays, after fees, commissions, and dividends are adjusted. By evaluating actual performance, an investor can determine how much he is actually making 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 that an investor will make. For example, if an investor opens a bank account or purchases a certificate of deposit (CD), they are 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 inflation into account. It is simply the amount of total interest paid on the investment.
However, if inflation is three percent, 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 investment, therefore, is actually only two percent.
Understanding actual performance is essential to understanding how well an investment performs and 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. Therefore, he is concerned with the amount of purchasing power that interest dollars from him will buy.
To determine the purchasing power you’ll have if you try to live off the interest on your investments, you need to know the actual return. Assuming that you will make five percent per year on an investment with a nominal return of five percent per year would be a serious mistake. Because the purchasing power of a dollar would drop by three percent with an inflation rate of three percent, you would really only be living on two percent instead of the five percent you expected.
Calculating actual performance is simple. Determine any external factors that cause the value of a saved dollar to increase. Then subtract those external factors from the nominal rate of return to find out what the real rate of return will be.
Smart Asset.
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