Real Returns

Returns are about money. Real returns are about value. Plan for real returns.

Real returns and nominal returns

If you earn a return of 4% on an investment, that is called the 'nominal' return, or 'money' return, or 'cash' return. But you don't want money. You want what money will buy.

The change in what money will buy is measured by inflation. If inflation over the same period is 3% you need £103 at the end of the year to buy £100 worth of goods in 'old money'. In terms of spending power you have earned just £1 in 'new money'.

This is your 'real' return. It is about equal to the nominal return minus inflation (4% minus 3%, or 1%). Because of compounding this is not quite true, but near enough. The precise real return is 1/103, or 0.97%.

The message is......

It is real returns that matter.

For any investment, get used to adding the income return to the capital gain and subtracting inflation to get the real total return. Always question whether any quoted returns are real or nominal.

Some investments are more inflation-proof than others. Their nominal returns tend to go up as inflation increases so that their real returns stay the same.

But that is another story.