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Savvy investors don’t just look at the interest rate on their investments. To make sense of how much your money is actually growing, you’ll need to understand the difference between nominal and real returns. Below we’ve unpacked both so you can hit your investment targets.
The nominal return tells you how much money your investment has made. Except there’s a giant caveat: this rate doesn’t factor in any of things that can reduce its value. The word “nominal” literally means “in name only.” And that’s precisely what it is: how much you earn in name only, before you cash it out and spend it in the real world.
Still, the nominal return is important. It’s the starting point for measuring the value of your investment. When you buy a bond or put your money into a savings certificate of deposit, the interest rate being offered is usually your nominal return.
Take a simple example:
You invest $100 in a one-year bond with an annual interest rate of 7 percent
After one year, you are paid $107
Your nominal return is 7 percent
See our guide to assessing assessing returns on debt-based investments.
When it comes to making smart investments, factoring in the inflation rate is essential. Inflation – or the rate at which the prices of goods and services are rising – eats away at the actual value of your investment. As prices go up, your money can buy less. In more precise terms, your purchasing power has been diminished.
That’s why central banks tend to hike interest rates when inflation gets too high. There’s no magic number for the perfect inflation rate, but the Federal Reserve tends to target 2 percent as a healthy rate. Just how serious is inflation? When central banks start hiking rates, it means they would rather slow the entire economy through higher borrowing costs than allow the value of everyone’s money to erode.
As an investor, you should think along the same lines: when inflation is climbing, you need to demand a higher rate of return. That will make sure your money has the same purchasing power. You may also want to switch up what types of assets you invest in, depending on whether inflation is high (more on that below).
That brings us to the all-important notion of real return on investment. This is the actual value of the investment, after you account for the effects of inflation. In simple terms, that just means subtracting the inflation rate from the nominal rate of return.
Take another example:
You invest $100 in a one-year bond with a 5 percent interest rate
Annual inflation is running at 3 percent
Your nominal return is 5 percent
Your real return, once you subtract inflation, is only 2 percent
Real returns give you a much sharper sense of the actual growth of your investment (hence the word “real”). In the above example, you get paid out five dollars in interest on your bond. But that five dollars is worth less than it was a year ago. Hence the real rate of return is lower. In a very high inflationary environment, you may even lose money on your investment if the rate of inflation exceeds that of the interest rate.
Inflation can get particularly nasty when it builds up over time. It’s also trickier to see the math over long time horizons. You can use online calculators to determine real returns and the effects of inflation.
Not all investments are affected by inflation equally. To keep your real rate of return high, consider diversifying across different assets.
Bonds and other fixed-income investments usually don’t keep up with the inflation rate. At the end of your investment, you get paid out the same rate, regardless of what happened with inflation during the interim period.
Other investments can fare better – stocks often keep up with inflation because companies can raise prices. That’s especially true of dividend-paying stocks, which can be a good hedge against inflation.
Learn more about: Halal dividend stocks
Some securities even have inflation protections built in. For example, Treasury Inflation-Protected Securities (TIPS) are US treasury bonds where the principal is periodically adjusted for inflation. Corporate Inflation-Protected Securities (CIPS) are another option.
Similarly, real estate and commodities like gold tend to rise in price with inflation, maintaining your real return.
Inflation isn’t the only thing that affects the real value of your investment. If you’re investing across multiple geographies, another major factor is fluctuations in the exchange rate, or the value of one currency relative to another.
Let’s take an example to drive the point home:
You invest $1000 into one-year Egyptian treasury bills
The treasury bills pay 10 percent annual interest
During the one-year investment period, the Egyptian pound drops in value by 25 percent against the US dollar
Had the currency remained stable, you would have been paid a $100 interest payment and come away with your principal plus $100, so $1100.
But since your money is now in Egyptian pounds, you have to convert back to US dollars at a much weaker FX rate. That means the value of your investment has dropped.
Even after your interest payment, you will come away with $825 after converting back to USD at the new weaker rate.
Of course, if the local currency strengthens, the opposite is true. You will make money on the interest rate plus the currency appreciation, increasing your real return.
Finally, when thinking about real returns you must consider taxes. Just like inflation, if you have to pay taxes on your nominal return, the value is lower. You’ll want to consider devising a tax strategy where higher taxed investments can be put in tax-advantaged accounts. This will help preserve your real return.
Learn more about: strategies for tax-efficient investing.
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
