(1 + nominal rate) ÷ (1 + inflation rate) - 1.
To demonstrate the calculations, say you buy a stock for $100, and its value increases to $120 exactly one year later. Let's also assume the inflation rate for that year was 2%. In this case, the nominal rate of your return is 20%. You calculate this by dividing the starting price into the difference between the ending and starting price.
These are the real rate of return calculations:
- The nominal rate plus 1 equals 1.2.
- The inflation rate plus 1 equals 1.02.
- 1.2 divided by 1.02 equals 1.176.
- 1.176 minus 1 equals 0.176, or 17.6%. This is the real rate of return.
In this case, inflation undercuts the 20% nominal growth by roughly 240 basis points.
The real rate of return and financial planning
Just a few years of inflation can dilute purchasing power noticeably. Over 10 or 20 years, the effects of inflation become increasingly significant. For example, what you can buy for $100 today would require $134.39 after 10 years of 3% annual inflation. In 20 years, you'd need $180.61 for the equivalent purchasing power.
Using real rates of return instead of nominal rates in your financial plans will account for those inflationary price increases. To put numbers to this concept, let's say you're projecting growth for your large-cap stock portfolio. For the expected return, you decide to use the average annual return for the S&P 500 large-cap index.
