The real rate of return is an investment's annual growth rate adjusted for inflation. Since inflation reduces the purchasing power of money, the real rate of return is essential for accurate financial projections and plans.
Definition
Defining the real rate of return
The real rate of return for an investment is the nominal rate discounted to account for inflation and its effect on purchasing power. The nominal rate is the investment's unadjusted annual growth rate. The formula for the real rate of return is:
(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.
Financial plans
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.
Between 1957 and 2023, the S&P 500 showed an annual average growth rate of 11.8%. However, average annual inflation during the same period was 3.6%. This means the real rate of return for the S&P 500 was about 7.9%. This growth rate is 390 basis points lower but reflects a more realistic view of how your investments could potentially appreciate.
Taxes and fees
About taxes and fees
Inflation isn't the only factor that works against your investment growth. Depending on the type of account you're investing in and the assets you hold, you may also need to consider taxes and investment fees. Note that the taxes on investment-related returns earned within a retirement account are deferred, so the following applies primarily to taxable brokerage accounts.
To find your after-tax rate of return before inflation, multiply your nominal rate by 1 minus the tax rate. If the nominal rate is 20% and the applicable tax rate is 15%, the after-tax return is 17%. The calculation is 0.20 x (1 - 0.15). You can then adjust the 17% rate for inflation using the real rate of return formula explained above.
As for investment fees, these siphon money away from your wealth-producing assets. Over decades, even seemingly small fees can reduce your investment balance by tens of thousands of dollars.
The impact of fees charged by advisors, funds, and account administrators is already embedded in your account performance. You probably cannot eliminate your investment fees, but you can try to reduce them. Strategies include negotiating with your advisor, choosing funds with low expense ratios, and complaining to your 401(k) administrator.
Application
Practical application
The difference between the real rate of return and the nominal rate becomes obvious in retirement planning. This is because retirement investors typically save for decades and then live off those savings for a few more decades. Over the course of 40 or 50 years, the inflation effect is dramatic.
As an example, let's say you intend to retire with $2 million in the bank in 2060. To plan for that outcome, you'll use a compound interest calculator like this to determine how much to invest monthly between 2024 and your planned retirement date.
Related investing topics
Every compound interest calculator requires an expected growth rate. Using the inflation-adjusted S&P 500 rate noted above of 7.9%, you'll save $911.53 monthly to reach your $2 million goal in 36 years.
On the other hand, if you use the nominal rate of 11.8%, the calculator says you need to contribute only $361.17 monthly. The problem is that this lower contribution won't give you $2 million in purchasing power in 2060. As a result, you'll be living on a 2026 budget while absorbing 2060 prices.
The takeaway? Use the real rate of return in your financial planning. Otherwise, inflation will undercut your ability to reach those long-term wealth goals.
