Take a look at this hypothetical situation: You are trying to decide how to invest your money. You are afraid to buy stocks because you’ve seen how drastically they can decrease. You don’t want to buy bonds because you’ve heard that they have to go down at some point. So, you decide to keep all of your money in the bank in insured accounts. If you earn 2% per year on your money, but prices are rising by 3% per year, the value of your net worth will steadily erode. You will not be able to buy the same things in the future with your money that you can afford to buy with it now. This is because you have experienced a negative “real” return.
So what are real returns? Well, your real return is calculated by subtracting inflation from your nominal or stated return. Your nominal return is the return stated on your investment product or account statement, the one that everybody mentions. In this instance, your nominal return is 2%, but because inflation is 3%, your real return is -1% (2%-3% = -1%).
We should all be much more mindful of real returns than nominal ones, but no one ever tracks them. I have never seen one calculated on an account statement (and it would be very impractical, if not impossible to do so). No one ever mentions their investment returns in light of the inflationary environment at the time, and failing to take inflation into consideration is a mistake.
I can still hear my wife’s grandmother talking about the great rates she got on CDs in the early 1980’s. What she didn’t know or care about then was that inflation was several points higher than her returns, so her real return was negative. She got better real returns on her CDs more recently, even with the lower nominal rates, because inflation was even lower.
If your CD has a 10% nominal return and inflation is running 12%, your real return is -2% (10%-12%). If your CD is yielding 3% and inflation is at 2%, your real return is 1% (3%-2%). Because of the ravaging effects of inflation, you would have better returns during the time period when CDs were yielding 3% in these scenarios.