Finance
Real vs. Nominal Returns
The percentage your money grew by (nominal) isn't the same as how much more it can actually buy (real) — inflation eats into the difference.
Definition
Nominal return is the percentage an investment grew by in raw dollar terms, with no adjustment for anything else.
Real return is the nominal return adjusted for inflation — what your money actually grew by in terms of purchasing power, not just in the number of dollars.
Why this exists
A dollar today and a dollar a year from now aren't stable, unchanging units. Because of inflation, a dollar a year from now typically buys a little less than a dollar today does. That means a percentage return measured in raw dollars can overstate how much better off you actually are, because part of that percentage gain is just keeping pace with a shrinking measuring stick, not real growth in what you can buy.
Real return strips that effect out, answering a more useful question: after accounting for inflation, how much more can this money actually buy than before? This matters because comparing nominal returns across different time periods, or different countries, can be misleading if inflation rates differ — a 10% nominal return during a year of 8% inflation represents far less real growth than a 10% nominal return during a year of 1% inflation, even though the nominal number is identical in both cases.
This is also why it isn't enough for an investment to just beat 0% to grow real wealth — it has to outpace inflation, not merely stay positive, for its real return to be positive at all. Cash sitting in a low- or no-interest account can show a positive (or zero) nominal return while quietly losing real value every year inflation runs above that rate.
Formula & mechanics
A quick approximation, and the more precise version it's approximating:
approximate: real return ≈ nominal return − inflation rate precise: real return = (1 + nominal return) / (1 + inflation rate) − 1
The subtraction is close enough for everyday purposes when rates are small — a few percent — but the gap between the two versions widens as the rates involved get larger.
Worked example
Suppose an investment returns 7% nominal in a year where inflation runs at 3%.
Approximate real return ≈ 7% − 3% = 4% Precise real return = (1.07 / 1.03) − 1 ≈ 3.88%
$10,000 invested grows to $10,700 in nominal dollars. But if a basket of goods that cost $10,000 at the start of the year now costs $10,300 (3% inflation), that $10,700 buys about 3.88% more of that same basket than the original $10,000 could — matching the precise real-return figure, not the rougher 4% approximation.
Try it yourself
Precise real return
3.88%
Approximate real return
4.00%
Gap between the two
0.12%
How the math works
The approximation just subtracts: nominal − inflation = 7.0% − 3.0% = 4.00%.
The precise version divides instead: (1 + nominal) / (1 + inflation) − 1 = 3.88%. At these rates, the two methods differ by 0.12% — a small gap here, but one that widens as the rates involved get larger, since the approximation ignores the interaction between the two rates.
Common misconceptions
“A positive nominal return always means you're better off.”
If inflation exceeds the nominal return, the real return is negative — you end up with more dollars, but those dollars buy less than your original amount could.
“Real return always equals nominal return minus inflation, exactly.”
Subtracting is a close approximation for small rates, but the precise calculation divides (1 + nominal) by (1 + inflation) instead. The two methods diverge more as the rates involved get larger.
“Inflation only matters for cash sitting still, not for invested money.”
Inflation erodes the purchasing power of any return that doesn't outpace it, invested or not. The real-return calculation applies to any nominal figure, not just idle cash.
Also in the Glossary: Nominal Return, Real Return