What is a 'Real Rate Of Return'

A real rate of return is the annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other external effects. This method expresses the nominal rate of return in real terms, which keeps the purchasing power of a given level of capital constant over time. Adjusting the nominal return to compensate for factors such as inflation allows you to determine how much of your nominal return is actually real return.

Explaining 'Real Rate Of Return'

Particularly during periods of high inflation, expressing rates of return in real values rather than nominal values offers a clearer picture of an investment's value.

Nominal vs. Real Values

Interest rates can be expressed in two ways: as nominal rates or real rates. The difference is 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.

Calculating Real Rate of Return

Assume your bank pays you interest of 5% per year on the funds in your savings account. If the inflation rate is currently 3% per year, the real return on your savings is 2%. In other words, even though the nominal rate of return on your savings is 5%, the real rate of return is only 2%, which means the real value of your savings only increases by 2% during a one-year period.

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Further Reading

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