Inflation and Real Returns

definition of Inflation

Inflation is the increase of cost of goods and services, and also the decline of purchasing power of a currency over time. These two concepts go hand-in-hand; you can estimate the purchasing power rate decline by the average increase in goods and services over a period of time. To put it simply, inflation makes your money buy less over time.

Nominal Rate of Return

The word nominal in business refers to any value that isn’t adjusted for any reason. These values can be rates or returns; the adjustment can be inflation. Therefore the nominal rate of return is the return on an investment that is unadjusted for inflation.

Real Rate of Returns

Conversely, the real rate of return is the annual percent of profit gained from an investment that is adjusted for inflation. The purpose of this rate is to show the purchasing power of profit earned, since time can decrease the value of money. There are two ways you can calculate the real rate of return: Single-Period and Multi-Year. The reason for this is because we must adjust for compounding when we’re trying to find the real rate of return across multiple years. The first formula displays the single-period and the second will show the multi-year.

The compounded real return is just a fancy way of repeating the real rate of return in each year. For example, to find the compounded real return you would be doing:

It’s a repetitive task, which you actually don’t really need to manually do anymore. If you’re curious, you can download this Google Sheet I made that calculates the Compounded Real Return. You can either create one, or just simply search one online, since I’m sure there are plenty of those.

Real Rate vs Nominal Rate

You might think that the real rate is just better than the nominal rate. Like why would you need to know the nominal rate if you can calculate the real rate? To put it simply, the nominal rate of return is commonly reported amongst businesses and firms since it shows actual dollar growth of an investment.

Nominal Rate

• Standard in Reporting

• Great for short-term analysis

• Easily observable

• Good for comparing investments in the same period

One major problem with nominal rates is that even though it can show you’re positive, your real return can be negative. For example, if your investment return is 5% but the inflation rate is 6%, you’d actually be -0.94%, despite the portfolio saying you’re making money.

Downsides of Real Return

In order to calculate real return of an investment, the investment would have had to be exposed to the year’s inflation, therefore you’re calculating the previous year’s real return, not the current. However, trailing is a collection of data from past events that can indicate an investment’s underlying trends, but isn’t a clear signal as to what it’ll be in the future.

SOURCES

Hargrave, M. (May 24, 2026). Understanding Real Rate of Return: Definition & Calculation Guide. Investopedia. https://www.investopedia.com/terms/r/realrateofreturn.asp

(Retrieved May 27, 2026). How inflation affects investments. US Bank: Wealth Management. https://www.usbank.com/investing/financial-perspectives/investing-insights/how-inflation-affects-investments.html