A look at real returns

Whenever you calculate or are presented with investment returns, they’re often in nominal terms, and not real ones. “Nominal” vs. “real” is an important distinction to understand.

A real return is one that has factored in inflation (and sometimes fees and taxes). For example, the S&P 500 has averaged annual returns of close to 10% over many decades, but that’s a nominal average. Remember that inflation was at work over that period, and that historically, inflation has averaged roughly 3% annually, though at times it has been much higher or lower. To arrive at the S&P 500’s long-term real return, you simply subtract the 3% inflation rate from the nominal average return of 10%, getting 7%.

Such differences have meaningful ramifications in our financial lives. For example, if you invest $5,000 per year for 30 years and average 8% gains, you’ll end up with about $612,000. That’s pretty good, but prices don’t remain the same over time — they tend to increase. That $612,000 may sound great today, when things we’re used to buying cost what they do today — but if inflation averages 3% annually over those 30 years, prices will be, on average, about 2.43 times what they are now. So a $50 restaurant meal might cost $121.50, and a six-pack of paper towels that goes for $8 today may cost around $19 in 30 years. Your $612,000 won’t go nearly as far then as it would today.

If you model the growth of your money using a real growth rate of 5% instead of 8%, that $5,000 annual investment for 30 years grows to $348,800. So you may actually end up with that $612,000 — but it will have the buying power of around $348,800 in today’s dollars.

These considerations are important for savings, too, not just investments. For example, if you’re earning 2% interest for many years on your savings, but inflation is averaging 3%, you’re actually losing purchasing power over time.

You can look up historical inflation rates and find inflation calculators at sites such as Inflationdata.com.