Investment
How to Calculate Real Return and Nominal Return
Considering Real Returns and Nominal Returns
Applying These Concepts to Investment
Negative Real Returns
Conclusion
Frequently Asked Questions (FAQs)
How to Calculate Real Return and Nominal Return
A real return is simply the return investors receive after accounting for inflation. The math is straightforward: If a bond returns 4% in a given year and the current inflation rate is 2%, then the real return is 2%. The same calculation can be used for bond funds or any other type of investment.
Similarly, the nominal return is the bond’s return minus the inflation rate. If a bond returns 5% and inflation is running at 2%, then the real return is 3%.
Considering Real Returns and Nominal Returns
These calculations exist because inflation reduces the purchasing power of every dollar of savings you hold. If you keep your money in a safe place, its nominal value remains constant, but the real value of each dollar shrinks due to inflation.
Think of it this way: Suppose this year, you need $200 to feed your family for a week. If inflation is running at 2%, it will cost you the same grocery cart of food $204 next year. If your investment returns are only 1%, you will have only $202 at the end of the year because your purchasing power has eroded by 1% between your nominal return and the 2% inflation rate. This means your real return is -1%. To manage your investments correctly, it’s important to pay attention to real returns.
Applying These Concepts to Investment
Real returns and nominal returns are important considerations in investing, but they are not the only ones. Sometimes, investors may accept a return lower than the inflation rate in exchange for safety. This may be especially true for older investors, as their safe investments may include Certificates of Deposit (CDs), money market funds, savings bonds, and U.S. Treasury bonds.
The virtue of these investments is that the risk of assumption is minimal. For example, the U.S. Treasury has never failed to pay scheduled interest on a bond. The flip side of this, however, is that these investments may have nominal returns lower than the inflation rate or, at worst, below that. This situation is known as a negative real return.
Negative Real Returns
Negative real returns is the term used to describe a nominal investment return that is equal to or less than the inflation rate. As part of its strategy to recover from the economy it experienced after the severe recession that began in 2007, the U.S. Federal Reserve lowered the federal funds rate to near zero in late 2008.
By doing so, the Federal Reserve made it cheaper for companies to borrow money for investment and expansion – a strategy called quantitative easing. One of the many benefits of this strategy is that it tends to lower the real unemployment rates, which the Economic Policy Institute estimates rose to over 10% in 2009.
But as a consequence of the same strategy, safe investment vehicles recommended by the financial investment community for retirees and those approaching retirement fell below the inflation rate.
This is an unusual situation; historically, government bonds have offered positive real returns. But after the Great Recession, investors continued to buy government bonds due to their status as a “safe haven” even when the real returns on these investments were negative.
Conclusion
The return
The real return on investment is not the only consideration or sometimes even the primary one. Investors also need to focus on other considerations, including their long-term goals, the duration of their investment horizon, and their risk tolerance.
In all cases, it is important to be aware of the impact of inflation on your investment returns. When evaluating an investment, be sure to consider the real return and real yield, rather than just looking at the nominal return or nominal yield. Paying attention to this will help you manage the purchasing power of your savings.
Frequently Asked Questions (FAQs)
What drives real returns?
To understand what drives real returns, you need to analyze what drives the two components of the real return: nominal return and inflation. The yield on a given bond rises and falls with market forces; when more investors want to buy bonds, the yield drops, and vice versa. There are three main causes of inflation: demand, cost, and the expansion of the money supply.
What happens to real GDP growth when Treasury yields fall?
Treasury yields are usually linked to real GDP growth and other indicators of economic health. When the economy is generally doing well, and real GDP is growing, investors may prefer riskier assets, so Treasury yields need to rise to attract investors. When the economy is in a downturn, investors may prefer the relative safety of Treasury bonds, which do not need to pay high yields like that.
Source: https://www.thebalancemoney.com/what-is-real-return-and-real-yield-417078
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