Real Return is the investment return adjusted for inflation, reflecting the true increase in purchasing power over time.
Real Return represents the actual rate of return on an investment after accounting for inflation, showing the increase in the investor's purchasing power. Unlike nominal return, which does not consider changes in price levels, real return provides a clearer picture of how much an investment's value has grown in terms of real economic value. It is calculated by subtracting the inflation rate from the nominal return or by adjusting the nominal return for inflation using a formula such as (1 + nominal return) / (1 + inflation rate) - 1. In finance and wealth management, real return is essential for evaluating long-term investment performance because inflation erodes the value of nominal gains. Measuring returns in real terms helps investors understand the true growth of their capital. This concept is particularly important when planning for future financial goals, such as retirement or wealth preservation, as it provides insight into whether investments are truly enhancing wealth or just keeping pace with rising prices.
Considering real return is critical in developing investment strategies that aim to preserve and grow wealth in real terms. Inflation can significantly diminish the effective returns on investments, especially fixed-income assets, which means nominal gains might be misleading if inflation is high. By focusing on real return, advisors and portfolio managers can make more informed decisions on asset allocation and risk management to safeguard and enhance purchasing power. For taxation and reporting purposes, understanding real return helps in accurately assessing the real gains subject to tax, as nominal returns might not reflect actual economic benefit. Additionally, real return considerations are vital in the governance of investment policies to maintain the family's or client's financial objectives through inflationary periods. This is why inflation-protected securities and real assets are often included in diversified portfolios aiming for positive real returns.
Suppose an investment generates a nominal return of 8% over one year, while inflation during the same period is 3%. The real return can be approximated as nominal return minus inflation, which is 8% - 3% = 5%. Using the precise formula, real return = (1 + 0.08) / (1 + 0.03) - 1 = 4.85%. This means the investor actually gained about 4.85% in purchasing power after inflation is considered.
Nominal Return
Nominal Return is the percentage change in the value of an investment without adjusting for inflation, representing the raw gain or loss over a period. The key difference from Real Return is that Nominal Return does not account for the erosion of purchasing power due to rising prices, potentially overstating the true economic benefit.
How is real return different from nominal return?
Real return accounts for inflation, showing the true increase in purchasing power, whereas nominal return is the raw percentage gain or loss on an investment without adjusting for inflation.
Why is understanding real return important for long-term investors?
Because inflation erodes the value of money over time, understanding real return helps investors assess whether their investments are genuinely growing their wealth in terms of purchasing power, which is crucial for long-term financial planning.
How can a family office protect against inflation to maintain real returns?
Including inflation-protected securities such as Treasury Inflation-Protected Securities (TIPS), real assets like real estate, and diversifying investments can help maintain positive real returns despite inflation.
