Question

Last year, an investor earned a 5% real rate of return on his portfolio. If inflation last year was 3%, what was the approximate nominal rate of return on his portfolio?

Answer 1

To calculate the nominal rate of return, add the real rate of return (5%) to the inflation rate (3%), resulting in an approximate nominal rate of return of 8%.

Step-by-step explanation:

The student's question pertains to how to calculate the approximate nominal rate of return on an investment when given the real rate of return and the inflation rate. To find the nominal rate of return, we use the formula: nominal rate = real rate + inflation rate. In this case, with a real rate of return of 5% and an inflation rate of 3%, the nominal rate of return would be 5% + 3% = 8%.

It is essential to understand that inflation erodes the real value of the nominal returns on investments. For instance, even if a nominal interest rate looks good on the surface, after accounting for inflation, the investor's purchasing power might not have increased as much as the nominal rate suggests. Furthermore, tax implications might worsen the situation, as taxes are often levied on the nominal gains without accounting for inflation.