Thursday, March 8, 2012

Nominal vs Real Return

Nominal returns are the total annual return that you received on the investment. Real return accounts for the effects of inflation.

Real Return = Nominal Return - Inflation Rate

For the purposes of this example I've assumed that $1 is invested at the beginning of 2012 and no additional investments are made for the rest of the study period. Since Warren Buffet knows a lot more about investing than I do, we'll use his 7% total return assumption. From 1914 to 2010 the average inflation rate was 3.38% so we'll go on and use that. There's a big difference in the dollar value at the end of 33 years.

The nominal return ends up turning $1 in to $9.33 of 2044 dollars. However the actual purchasing power that you have increased after accounting for inflation is only $3.23. The real return is only 35% of the nominal return. For that you can thank inflation This exercise goes to show that inflation is definitely something to take into account when planning your retirement saving.

Little changes in assumptions can make a huge difference in the final values. I've run the calculations for several different scenarios and the results are in the following table.

Nominal vs Real Return
Nominal ReturnInflation RateReal ReturnNominal DollarsReal Dollars

You can use the previous table to multiply your total investment balance by the real dollars column for whatever scenario you wish to get an approximation of your portfolio if you don't contribute anything else and let it be for 33 years. For example I currently have just under $80,000 across all my investment accounts. I'll take the 7% return with 3.38% inflation, the real dollar column shows $3.23. So $80,000 x $3.23 = $258,400. That's not bad but if you have followed this blog I'm looking for much better than that.

The scenario that I expect to play out is something in the area of the 7% nominal return with the 3% inflation rate. That would mean that every dollar that was invested at the beginning of 2012 would turn in to $3.65 of purchasing power. While inflation is a big concern in the long run, I believe that some effects of inflation can be accounted for through smarter purchases and getting your expenses to align with your true life goals. Of course so many variables go in to any projections that these are a rough guide. It's good to play around with the numbers to see what different scenarios would produce. We're all searching for the right balance between saving enough plus a little bit more for comfort so that we can enjoy our life as it goes. I hope that we can all find that balance.

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