Nominal vs Real: The Difference That Changes Everything
When a savings account advertises 5% interest or a fund reports 10% annual returns, those figures are nominal returns — they reflect the raw percentage change in the monetary value of the investment. But money is not valuable in itself. What matters is purchasing power: how much the money can buy.
Inflation erodes purchasing power. If prices rise 6% per year while your investment grows 8%, you have not become 8% wealthier in real terms. The goods and services you could buy have become more expensive, and after adjusting for that, your real gain is approximately 2%.
The Fisher Equation
The relationship between nominal returns, real returns, and inflation is expressed by the Fisher equation, named after economist Irving Fisher. The precise version is:
(1 + real return) = (1 + nominal return) / (1 + inflation rate)
In practice, for moderate inflation levels, the approximation is sufficient:
real return ≈ nominal return − inflation rate
So an 8% nominal return with 6% inflation gives a real return of approximately 2%. The approximation understates the true real return slightly when inflation is high, but the intuition holds.
Why Nominal Returns Can Deceive
Marketing materials for investment products almost always present nominal returns. This is not necessarily dishonest, but it makes comparisons across time periods misleading, and it flatters performance during high-inflation eras.
Consider two hypothetical decades. In the 1970s UK, equities returned roughly 15% per year nominally. In the 2010s, they returned roughly 8% per year nominally. The 1970s figure sounds more impressive — but with inflation averaging around 13% in that decade, the real return was approximately 2% per year. The 2010s return, with inflation averaging around 2%, produced a real return of roughly 6% per year. The apparently inferior decade was actually far better for investors in real terms.
This also explains why "10% nominal returns" from fixed deposits in high-inflation economies are not the windfall they appear to be. The investor is, in many cases, barely staying ahead of inflation — or falling behind it.
Historical Real Returns
Despite the ravages of inflation, equities have delivered impressive real returns over the long run. Research by Elroy Dimson, Paul Marsh, and Mike Staunton (London Business School) across 23 countries over more than 100 years finds that equities have delivered real returns of approximately 5% per year in the UK and somewhat higher in the US over the very long run, after inflation. Government bonds have delivered much lower real returns, and cash has often barely kept pace with inflation or trailed it.
These figures underpin the case for holding equities over long time horizons. The nominal headline numbers are largely irrelevant — it is the real return that determines whether an investor retires comfortably or runs out of money.
The Practical Implication
Investors must always translate nominal figures into real ones. When evaluating whether an investment meets your needs, ask not "does this return beat last year's?" but "does this return beat inflation, and by enough margin to justify the risk?" The goal of investment is to grow purchasing power, not to accumulate larger nominal numbers.