Real vs. nominal returns: the number that actually matters
Key takeaways
04 · ideas- Real return = nominal return − inflation rate
- At 3% inflation, $100 today is worth $74 in 10 years
- Always compare investments using real returns
- TIPS and I-bonds directly protect against inflation
Basic level
The essentials · 1 min
When an investment earns 7% and inflation runs at 3%, your real return is roughly 4% — meaning you can actually buy about 4% more stuff with your money.
Why it matters:- A savings account paying 0.5% with 3% inflation has a real return of -2.5% — you're losing purchasing power
- A bond paying 4% with 3% inflation earns a real return of ~1%
- Stocks averaging 10% nominal with 3% inflation earn a real return of ~7%
Always think in real terms when comparing long-term investments or planning retirement.
Intermediate level
How it applies · 1 min
The compounding effect of inflation
| Years | $100,000 in cash (0%) | $100,000 in stocks (7%) | Real value of stocks |
|---|---|---|---|
| 10 | $100,000 | $196,715 | $146,228 |
| 20 | $100,000 | $386,968 | $213,826 |
| 30 | $100,000 | $761,226 | $312,630 |
Assuming 3% annual inflation
Cash loses 26% of its purchasing power in 10 years and 56% in 30 years. Stocks more than triple in real value over 30 years.
Inflation-protected options:- TIPS (Treasury Inflation-Protected Securities): Principal adjusts with CPI. Real yield currently ~1.5–2.5%
- I-Bonds: Fixed real rate + inflation rate, capped at $10,000/year per person
- Real estate: Rents and property values tend to track inflation over time
- Equities: Companies pass inflation to consumers; long-term best inflation hedge
Advanced level
The math, step by step · 1 min
The Fisher equation
The precise relationship between nominal returns, real returns, and inflation:
Solving for real return:
For 7% nominal, 3% inflation: r_{real} = \frac{1.07}{1.03} - 1 = 3.88\%
The simplified approximation r_{real} \approx r_{nominal} - i gives 4%, which is close enough for planning.
Why the approximation overstates real returns: At higher rates, the interaction term r_{nominal} \times i matters more. At 10% nominal and 6% inflation: simplified = 4%, exact = 3.77%.
Expected real returns by asset class (long-run historical):- US large-cap stocks: ~7% real
- International stocks: ~5–6% real
- Real estate (REITs): ~4–5% real
- Bonds (10-yr Treasury): ~1–2% real
- Cash/T-bills: ~0% real (barely keeps pace with inflation)