INFLATION AND REAL RATES OF RETURN

Real vs. Nominal Rates


It is an important element to consider in an investment. Unfortunately many people ignore real value of their returns and exclusively focus on nominal value. For instance, your t-bill yielded 3.5% last year but inflation rate for the year was 4%. A dollar invested in the t-bill became $1.035. That sure is increase in nominal value but are you truly better off? Well, no. Because after the inflation, you actually incurred a loss of 0.5%. Compared to last year, you have less purchasing power.
As a shrewd investor, you must take inflation into account and compute real rate of return.

Fisher effect:  Approximation
nominal rate = real rate + inflation premium
Note that this is only an approximation and not an accurate formula but it is close enough. So no further complex computation is not needed.

R = r + i  or  r = R - i
R = nominal and r = real
Example  r = 3%, i = 6%
R = 9% = 3% + 6%  or  3% = 9% - 6%