Real Rate of Return

When you typically talk about your return on an investment, you are talking about the nominal return. One of the risks associated with any investment is inflation. When you factor inflation in the discussion you are talking about the real rate of return.

In order to illustrate this point, I'll use a hypothetical example. Let's assume that you've been investing for two years and your annual returns were 10% in the first year and 15% in the second year. In which year did you do better? In order to really properly answer this quesion, you need to know the annual inflation rates. If in the first year, the inflation was 3% and in the second year it was 10%. As a result, you actually did better in the year that you earned 10%.

In order to calculate the real rate of return you:

return = [[( 1 + nominal return) / (1 + inflation) ] - 1] * 100