How this number is made
A return is a real gain only if it beats the rise in prices. Eight percent in a year when prices rise three percent does not leave you five percent better off. The exact figure is a little less, because the inflation hits the whole ending amount, not just the gain.
- Nominal return is the rate the account or the investment actually credited, before inflation.
- Inflation is the price index you live with, for the same period. A country’s headline CPI is a start, not your personal basket.
- Read the headline, not the simple gap, when either percent is large.
Formula
Real return = (1 + nominal) ÷ (1 + inflation) − 1.
Worked example
8% nominal and 3% inflation is a real return of 4.85%, not 5%. The half point is the inflation on the gain itself. Subtracting the two percents is the approximation, and it runs high.
Questions
Can the real return be negative when I made money?
Yes. A 2% savings rate in a 6% inflation year is a real loss. The balance went up. What it buys went down.
Where does tax go?
Not in the formula. If the nominal return is taxed, use the after-tax nominal rate as the input. Inflating a pre-tax return overstates what you keep.