Your Returns Are Lower Than You Think
You Must Understand the Difference Between Nominal and Real Returns
As investors embark on their financial journeys, understanding the nuances of returns is paramount. Two key concepts that often come into play are nominal and real returns. While both metrics measure the performance of investments, they encapsulate distinct aspects that can significantly impact an investor's perception of their financial gains. Let’s unravel the difference between nominal and real returns and explore why each is essential in assessing investment success.
Nominal Returns: The Surface View
Nominal returns, also known as stated or current returns, represent the absolute percentage gain or loss on an investment or portfolio without factoring in the impact of inflation or taxes. This straightforward measure provides a snapshot of how much the investment or portfolio has grown or declined over a specified period. While nominal returns offer a clear and easily interpretable metric, they do not provide a comprehensive understanding of the investment's actual purchasing power.
Real Returns: Accounting for Inflation and Taxes
Real returns, on the other hand, take inflation and taxes into account, providing a more accurate representation of an investor's purchasing power. A quick way to calculate real returns is to subtract the inflation rate from the after-tax nominal return. The resulting figure reflects the actual increase or decrease in the value of the investment after considering the eroding effects of inflation and taxes. After Tax Real Returns offer a more realistic perspective on how an investment or portfolio performs in terms of its ability to maintain or enhance one's standard of living over time.
The Impact of Inflation and Taxes
Inflation and taxes are the silent forces that diminish the purchasing power of money. Nominal returns, while showcasing the absolute growth of an investment, may paint an overly optimistic picture if inflation and taxes are not considered. Real returns, by factoring in both of these, provide a clearer understanding of whether an investment or portfolio is truly growing in value or merely keeping pace with the rising cost of living.
Illustrative Example
Consider an investment that yields a nominal return of 10% in a year. At first glance, this seems like a solid gain. However, if inflation for the same period is 3%, the real return would be close to 7% (many use this approximation: 10% - 3%). This adjusted figure accounts for the fact that the purchasing power of the returns has been reduced by inflation. Investors can use real returns to gauge the true growth of their investments after considering the impact of rising prices. But what about taxes? Yes, these need to be considered as well in order to accurately figure out your true (After Tax) Real Rate of Return, aka your “Purchasing Power.” Here’s an example:
Assume:
Nominal Rate of Return on your portfolio = 10%
Tax Rate on Capital Gains = 20%
Inflation Rate = 3% (realistic given 2022)
After Tax Nominal Rate = Nominal Rate * (1 – Tax Rate) = 10% * (1- 20%) = 8%
After Real Rate of Return = (1 + After Nominal Rate) / (1 + Inflation Rate) -1
= (1+8%)/(1+3%) = 4.85% ... ouch!
Less than half of your Nominal Rate of Return.
In the realm of investments, nominal and real returns play distinct roles in providing insights into performance. Nominal returns offer a straightforward measure of absolute gains or losses, while real returns offer a more nuanced understanding by considering the erosive effects of inflation and taxes. Consider both metrics to make informed decisions about portfolios, but understanding your true purchasing power is more important.
Enjoy and be safe.