Real Rate of Return Calculator
Your Real Rate of Return:
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When you invest or save money, you're usually looking at a nominal rate of return. This is the stated interest rate or growth percentage your investment is expected to achieve. For instance, if you have a savings account that offers a 5% annual interest rate, that 5% is your nominal rate of return.
However, the money in your account doesn't exist in a vacuum. The prices of goods and services tend to increase over time due to inflation. Inflation erodes the purchasing power of your money. This means that even if your money grows by 5% nominally, its ability to buy things might not increase by the full 5% if inflation is also present.
This is where the real rate of return comes in. The real rate of return adjusts the nominal rate of return to account for the effects of inflation. It tells you how much your purchasing power has actually increased (or decreased) over a period.
Why is the Real Rate of Return Important?
The real rate of return provides a more accurate picture of your investment's performance and its impact on your lifestyle. If your nominal rate of return is 5% and the inflation rate is 2%, your real rate of return is approximately 3%. This means your purchasing power has increased by about 3%.
Conversely, if your nominal rate of return is 3% and the inflation rate is 4%, your real rate of return would be negative. In this scenario, despite your money growing in quantity, its purchasing power has actually decreased. You would be able to buy less with your money at the end of the period than you could at the beginning.
How to Calculate the Real Rate of Return
The most accurate formula to calculate the real rate of return is:
Real Rate = ((1 + Nominal Rate) / (1 + Inflation Rate)) – 1
Remember to convert your percentages into decimals before using this formula (e.g., 5% becomes 0.05, 2% becomes 0.02).
Let's look at an example:
- Suppose your investment has a Nominal Rate of Return of 7.5%.
- The current Inflation Rate is 3.2%.
Using the formula:
- Nominal Rate (decimal) = 7.5 / 100 = 0.075
- Inflation Rate (decimal) = 3.2 / 100 = 0.032
- Real Rate = ((1 + 0.075) / (1 + 0.032)) – 1
- Real Rate = (1.075 / 1.032) – 1
- Real Rate = 1.041666… – 1
- Real Rate = 0.041666…
To convert this back to a percentage, multiply by 100:
Real Rate of Return = 0.041666… * 100 = 4.17% (approximately)
This means that after accounting for inflation, your investment has effectively increased your purchasing power by about 4.17%.
When Inflation is Higher Than the Nominal Rate
It's also important to understand what happens when inflation outpaces your nominal returns. Consider these figures:
- Nominal Rate of Return: 2.0%
- Inflation Rate: 6.0%
Calculation:
- Nominal Rate (decimal) = 0.02
- Inflation Rate (decimal) = 0.06
- Real Rate = ((1 + 0.02) / (1 + 0.06)) – 1
- Real Rate = (1.02 / 1.06) – 1
- Real Rate = 0.962264… – 1
- Real Rate = -0.037735…
Real Rate of Return = -3.77% (approximately)
In this scenario, your investment is losing purchasing power. While your money balance increased by 2%, the cost of goods and services increased by 6%, meaning you can actually buy less with your money now than before. This highlights the critical importance of aiming for a nominal rate of return that exceeds the rate of inflation to achieve true wealth growth.