Do you know the difference between Nominal Rate of Return & Real Rate of Return?
Interest rates can be expressed in two ways, as nominal rates or real rates. The difference is that nominal rates are not adjusted for inflation, while real rates are adjusted. As a result, nominal rates are almost always higher, except during those rare periods when deflation, or negative inflation, takes hold.
Real rate of return is the annual percentage of profit earned on an investment, adjusted for inflation. Therefore, the real rate of return accurately indicates the actual purchasing power of a given amount of money over time.
The real rate of return is calculated by subtracting the inflation rate from the nominal interest rate. The formula is:
Real rate of return = Nominal interest rate − Inflation rate
Example: Assume a Fixed Deposit pays an interest rate of 6% per annum. If the inflation rate is currently 4% per annum, the real return on your savings is only 2%.
The general rule in economics is that the value of money today will not be equal to the same amount of money in the future. Also known as the time value of money, this is a central concept in finance theory, which takes into account factors such as inflation.
Other Factors Affecting Real Rate of Return
The problem with real rate of return is that you don’t know what it is until it has already happened. That is, inflation for any given period is a “trailing indicator” that can only be calculated after the relevant period has ended.
In addition, the real rate of return figure isn’t entirely accurate until it also accounts for other costs, such as taxes and investing fees.