Final answer:
The statement is false because nominal returns do not include inflation. Real returns are obtained by subtracting inflation from nominal returns, providing a better measure of an investment's actual gain in buying power. Taxes can further impact this calculation, as they are charged on nominal gains without adjusting for inflation.
Step-by-step explanation:
To answer the student's question, the statement that the index total return is a "nominal" return that includes inflation is false. The nominal return refers to the return on an investment without adjusting for inflation. To obtain the real return, we must indeed subtract the rate of inflation.
For instance, if an investor receives a 5% nominal interest rate on an investment, and the inflation rate is 3%, the real interest rate is 2% (5% nominal rate - 3% inflation rate). This calculation is essential because high inflation can significantly erode the purchasing power of nominal gains, leading to a misleading picture of an investment's performance.
Taxes can exacerbate the situation, as investors are taxed on their nominal gains without any adjustment for inflation. This creates a scenario where investors might owe taxes on gains that haven't resulted in any actual increase in purchasing power, particularly when inflation rates are high.