Real Return

When it comes to measuring investment returns there is more than one method. The most common is nominal return which includes inflation. The other measure of return is called real return. Real return is measured by taking the nominal return less the inflation rate. Real return is vital because it measures the increase in purchasing power that your investments generate.

If Investor A achieves a 10% return and Investor B achieves a 1% return, most people would say that Investor A did much better than Investor B. Let’s now say that Investor A had to deal with an inflation rate of 10% and Investor B was in a 0% inflation environment. After inflation Investor A actually did not increase their purchasing power while Investor B added 1% to their purchasing power. This is important because even though Investor A had a nominal return that was 10x that of Investor B they can’t buy more than before. On the other hand, Investor B would have added 1% to their purchasing power. Meaning the 1% nominal return is actually better than the 10% return when adjusted for inflation.

Let’s take a look at how the three primary asset classes have performed before and after inflation.  As you can see, stocks have easily produced a positive real rate of return with bonds offering a real return equal to roughly one-third that of stocks and cash-type investments producing a fractional real return.

After inflation, taxes and a recommended maximum 4% annual withdrawal rate for retired clients the only asset class that will protect their purchasing power is stocks.  That is why stocks have to play an important role in a retirees investment portfolio. While bonds do not offer the same long-term growth potential they need to be included in a balanced portfolio.  They are a more dependable source of income and will serve as a ballast when stocks experience periodic setbacks. And while cash-type investments are safe in the short-term they expose an investor to the risk that their purchasing power will decline due to inflation.