Understand How to Calculate Real Returns

A real return is the rate of return you receive after the impact of inflation. As discussed earlier, inflation has a negative impact on your investments because your money will buy less in the future. For example, forty years ago a gallon of gas cost twenty-five cents per gallon; currently, gas costs $2.90 per gallon. While the gas hasn’t changed (much), the price has increased. To keep your real return constant (in other words, to maintain your buying power), you must actually earn more money in nominal terms.

Traditionally, investors have calculated the real return (r_r) as simply the nominal return (r_n), or the return you receive minus the inflation rate (π). This method is incorrect.  It is preferrable to always use the following formula:

(1 + nominal return (r_n)) = (1 + real return (r_r)) * (1 + inflation (π))

To solve for the real return, divide both sides of the equation by (1 + inflation (π)). Once you've divided, the equation looks like this:

(1 + nominal return (r_n))/(1 + inflation (π)) = (1 + real return (r_r))

Then, subtract one from both sides to get the following:

Real return (r_r) = (1 + nominal return (r_n))/(1 + inflation (π)) – 1