How to Calculate The Average Real Return

The average real return is a crucial financial metric that measures the actual growth of an investment after accounting for inflation. Unlike nominal returns, which don't account for inflation, real returns provide a more accurate picture of an investment's true performance.

What is the Average Real Return?

The average real return is the average percentage increase in the purchasing power of an investment over a specific period. It's calculated by adjusting the nominal return for inflation, which allows investors to compare returns across different time periods.

Real returns are particularly important for:

Long-term investors who want to measure true wealth growth
Comparing investment performance across different economic periods
Assessing the effectiveness of inflation hedging strategies
Making informed decisions about future investments

Unlike nominal returns, which simply measure price appreciation, real returns account for the erosion of purchasing power due to inflation. This makes them more meaningful for evaluating investment performance over time.

The Formula for Real Return

The formula for calculating the average real return is:

Average Real Return = [(1 + Nominal Return) / (1 + Inflation Rate)] - 1

Where:

Nominal Return is the actual percentage increase in the investment's value
Inflation Rate is the percentage increase in the general price level

This formula effectively "deflates" the nominal return by the inflation rate, giving you the true growth in purchasing power.

Step-by-Step Calculation

Determine the nominal return of your investment for the period
Find the inflation rate for the same period
Add 1 to both the nominal return and inflation rate
Divide the adjusted nominal return by the adjusted inflation rate
Subtract 1 from the result to get the average real return

For multiple periods, calculate the real return for each period separately and then average them together.

Worked Example

Let's calculate the average real return for an investment that had a nominal return of 8% over a year, with an inflation rate of 3% during the same period.

Nominal Return = 8% = 0.08
Inflation Rate = 3% = 0.03
Adjusted Nominal Return = 1 + 0.08 = 1.08
Adjusted Inflation Rate = 1 + 0.03 = 1.03
Real Return Factor = 1.08 / 1.03 ≈ 1.0485
Average Real Return = 1.0485 - 1 ≈ 0.0485 or 4.85%

This means the investment provided a real return of 4.85% after accounting for inflation.

Interpreting the Results

Interpreting real returns requires understanding several key points:

Positive real returns indicate that the investment's purchasing power increased
Negative real returns mean the investment lost value relative to inflation
Zero real returns suggest the investment kept pace with inflation

Comparing real returns across different investments is more meaningful than comparing nominal returns because it accounts for the time value of money and inflation.

Remember that real returns can be negative even if nominal returns are positive, especially during periods of high inflation.

Frequently Asked Questions

What's the difference between nominal and real returns?

Nominal returns measure price appreciation without accounting for inflation, while real returns adjust for inflation to show true purchasing power growth.

How do I find historical inflation rates?

You can find historical inflation rates from government sources like the Bureau of Labor Statistics (BLS) in the US or the Office for National Statistics (ONS) in the UK.

Can real returns be negative?

Yes, real returns can be negative if inflation outpaces the investment's growth, even if the nominal return is positive.

Why is real return important for long-term investing?

Real returns help investors measure true wealth growth over time, making them more valuable for comparing investment performance across different economic periods.