Getting to grips with your money: Understanding the difference between nominal and real returns

Julie Brownlee, Fsp Invest, 09 Apr. 2015

Tags: returns, rate of return, nominal return, real return, nominal, real, rates of return, money, inflation, impact of inflation,

Wherever you put your money to work, you want to see it working for you.

If that’s in a savings account, a unit trust or other form of investment, you’ll be keeping an eye on the returns your money is earning.

But what rate of return are you looking at? It’s vital you concentrate on the real return and not the nominal return.

Read on find out more…

You need to know the real returns on your investments

There is a big difference between the nominal returns you may earn on your investments and the real returns.

If you’re only paying attention to the nominal return, you could actually be losing money.

It all comes down to the impact of inflation.

The difference between nominal rates and real rates

A nominal return is the rate of return you receive when you don’t take inflation into account. On the other hand, a real return is the rate of return you receive when you take inflation into account.

Inflation eats into your purchasing power. If inflation is sitting at 5%, it essentially means goods and services are now costing you 5% more than they did a year ago.

This is important when it comes to your investments. If your investments aren’t achieving a rate of return in excess of inflation, you’re losing money.

The impact of inflation on your returns

Let’s take a look at an example to show the difference between nominal returns and real returns…

Say your savings account pays you an annual rate of 6%, this is the nominal interest rate. In other words, the cash in your savings account is earning a nominal rate of return of 6%.

If inflation is sitting at 5%, the real interest rate is 1% (6%-5%). In other words, the cash in your savings account is earning a real rate of return of 1%.

If your savings account was only paying 4% as its rate of interest, you’d actually be losing money in your account as inflation is higher.

When weighing up your investment returns, you must look at it in real terms. Otherwise you could be losing money. You want to seek out investments where you money is bettering the rate of inflation and earning a positive real return.

So there you have it, understanding the difference between nominal and real returns.

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