Question

The index total return is a "nominal" return that includes inflation; to get to the real return, we must deduct inflation.

A. Nominal return
B. Real return
C. Inflation-adjusted return
D. Total return

Answer 1

Investment returns are measured as the actual rate of return, which includes capital gains and interest without adjusting for inflation. The real return is derived by subtracting the inflation rate from the nominal return. Recognizing this distinction is essential for accurate financial assessment.

Step-by-step explanation:

When examining investment performance, there are two crucial concepts: the actual rate of return and the inflation-adjusted return. The actual rate of return is the total rate of return, which includes any capital gains and interest paid on an investment at the end of a specified time period. However, it is essential to distinguish this from the real or inflation-adjusted return, which accounts for changes in purchasing power due to inflation.

The nominal return refers to the return reported without any adjustments for inflation. To calculate the real return, you must deduct the rate of inflation from the nominal return. For example, if the nominal interest rate is 7% and inflation is 3%, the real interest rate effectively becomes 4%. Importantly, if deflation occurs, this can increase the real interest rate. Thus, understanding the difference between nominal and real returns is vital for investors to assess the true performance of their investments.