Real return

In plain words

Your savings account paid 5% last year, so $1,000 became $1,050. But in the same year the prices of everything you buy rose 3%. Your extra $50 did not buy $50 more of stuff: in things you can actually buy, you are only about 2% ahead. That 2% is your real return; the 5% is the nominal return.

Real return ≈ nominal return − inflation. If inflation is higher than what your money earns, the real return is negative: you have more dollars and can buy less.

Over long periods the difference is huge. Since 1871, US stocks returned 9.4% a year with dividends, but 7.1% after inflation. Cash in Treasury bills earned 3.5% a year since 1934, and −0.1% after inflation.

Example

One level deeper

The exact formula is named after the economist Irving Fisher: (1 + nominal) = (1 + real) × (1 + inflation). At 20% interest and 15% inflation, the quick subtraction says 5%, but the real return is 4.3%.

Taxes are charged on the nominal return, not the real one. Earn 5% while prices rise 3% and pay 25% tax on the interest: you keep 3.75%, which is only 0.7% after inflation. When inflation runs high, savers can pay tax while losing purchasing power.

Bonds tell the same story. Since 1871, 10-year US Treasuries returned 4.5% a year before inflation and 2.4% after. The purchasing power of the dollar is the yardstick for all of these.

$1 in US stocks since 1871: in dollars and in what it buys

Both lines start with $1 in 1871 and reinvest every dividend. The upper line counts dollars; the lower one counts what those dollars can buy, in 1871 prices. The widening gap between them is a century and a half of inflation.

Why it matters

It is the return that matters for your life: what you can buy, not how many dollars you have.

It shows which savings actually grow. When a bank pays less than inflation, cash loses value slowly but surely.

Long-term plans should use real numbers. A plan built on a 10% return in a world of 3% inflation is really counting on about 6.8%.

A common mistake