What is Real Rate of Return?
The Real Rate of Return (%) measures the percentage return earned on an investment after adjusting for the inflation rate and taxation, unlike the nominal rate.
Table of Contents
Real Rate of Return Formula
The real rate of return is typically viewed as a more accurate return metric since it considers the factors that affect the actual return, namely inflation.
The real return is calculated using the formula shown below.
Where:
- Nominal Rate: The nominal rate is the stated rate of return on an investment, such as the offered rate on checking accounts by banks.
- Inflation Rate: The inflation rate is most often estimated using the Consumer Price Index (CPI), a price index that tracks the average change in price across time of a chosen basket of consumer goods and services.
For example, let’s assume that your portfolio of stocks generated a stated annual return of 10%, i.e. the nominal rate.
However, let’s say that inflation was 3% for the year, which reduces the 10% nominal rate.
The question now is, “What is your portfolio’s real rate of return?”
- Real Return = (1 + 10.0%) ÷ (1 + 3.0%) – 1 = 6.8%