Nominal vs real return

The nominal return is the figure a statement shows: $10,000 that ends the year at $10,600 returned 6%. The real return asks how much more the $10,600 buys than the $10,000 did. It divides one plus the nominal return by one plus inflation and subtracts one: (1.06 ÷ 1.03) − 1 is 2.91%. The shortcut, nominal minus inflation, gives 3%, close at low rates and a little high.

A projection years out has to pick a unit. In nominal dollars, the dollars of each future year, it grows the balance at a nominal return and grows a future cost at its own inflation rate. In real dollars, today's dollars, it grows the balance at a real return and holds the cost at today's price. Both frames reach the same answer when they are kept apart; a nominal return set against a cost at today's price, or a real return against a cost inflated forward, does not.

A cost that inflates at its own rate, faster or slower than prices in general, is easier to follow in nominal dollars, because its own rate stays a visible input. A spending need that keeps pace with prices in general is easier to follow in real dollars, because the figure reads the same as a price today.

A $10,000 balance earns 6% in a year and ends at $10,600. Prices rise 3% over the same year, so what cost $10,000 at the start costs $10,300 at the end. The $10,600 buys what $10,291.26 bought at the start, a real return of 2.91%. The shortcut, 6% minus 3%, says 3%.

Held for 18 years at the same rates, with nothing added or withdrawn, the balance reaches $28,543 in nominal dollars. Prices over those years rise by a factor of 1.7024, so the $28,543 buys what $16,766 buys today. Compounding the 2.91% real return for 18 years from $10,000 gives the same $16,766; compounding the 3% shortcut gives $17,024, $258 too high.

Balance today

$10,000

Nominal return

6%/yr

Inflation

3%/yr

Real return, 1.06 ÷ 1.03 − 1

2.91%/yr

Nominal balance, $10,000 × 1.06¹⁸

$28,543

Price level after 18 years, 1.03¹⁸

× 1.7024

Real balance, $28,543 ÷ 1.7024

$16,766

Over a long horizon, much of a nominal figure is inflation. In the example, $11,777 of the $28,543 is the rise in prices: the balance nearly triples in dollars and buys about 1.68 times what $10,000 buys today. A nominal projection read against a price quoted today looks larger than it is.

The return and the cost have to be in the same unit for a comparison between them to hold. A nominal return against a cost at today's price overstates how much of the cost the balance covers; a real return against a cost inflated forward understates it. That is why a planner states which kind of return it asks for.

Taiga Finance's planners each work in one frame, and the field says which. The “College savings” planner under Scenarios works in nominal dollars. Its “Assumptions” hold “College-cost inflation”, 5%/yr by default, and “Nominal annual return”, 6%/yr by default. The bill for a college year is today's cost grown at the college-cost rate to that year, and the balance grows at the nominal return, so both sides of the comparison are in the dollars of the year the bill is due. In the working behind the projection, the growth row reads “growing at 6% nominal · at enrollment” at the default.

The “Retirement savings” planner works in real dollars, at today's prices. Its rate is “Real return” under “Assumptions”, 5%/yr by default, and an info note beside the field gives the basis: a 60/40 portfolio of the S&P 500 and 10-year US Treasury bonds from 1928 to 2024, which “compounded about 5% a year after inflation”. The field's caption reads “After inflation”, and the projection runs at that one expected real return every year.

The public college savings calculator on this site uses the nominal frame and the same defaults: “Nominal annual return” at 6% and “College-cost inflation” at 5%, with the cost per year entered at today's price and inflated forward to the enrollment year.