What is Real Return?
Real return measures how much your investment's purchasing power actually increased after accounting for inflation. The approximate formula is: real return = nominal return minus inflation rate. For precise calculations, use the Fisher equation: (1 + nominal) / (1 + inflation) - 1. If your portfolio earned 8% nominally and inflation was 3%, your real return is approximately 4.85%.
Why Real Return Matters
Retirement planning must be based on real returns because your future expenses will be at inflated prices. A portfolio growing at 5% nominal during 4% inflation is barely preserving purchasing power. Historically, US equities have delivered about 7% real returns, bonds about 2%, and cash near 0%. These long-run real return expectations form the foundation of asset allocation decisions.
Key Considerations
During periods of high inflation, even seemingly strong nominal returns can translate to negative real returns. In the 1970s, US stocks delivered positive nominal returns in most years but lost purchasing power after double-digit inflation. Inflation-linked bonds (TIPS) guarantee a real return, making them valuable for conservative investors focused on preserving purchasing power.