What Is an Inflation Adjusted Return?

Are you getting the full picture of your investment returns? 

High nominal returns might look impressive, but they can be misleading if you ignore inflation. Inflation-adjusted returns show the real picture by factoring in the rising cost of living. This clearer perspective helps you make better plans for big financial goals, like retirement or major purchases. 

In this article, we’ll break down what inflation-adjusted returns are, why they matter more than nominal returns, and how they can influence your portfolio strategy during inflationary periods.

Demystifying Inflation-Adjusted Returns

Real rates of return, when they are expressed in real terms, are something which economists call the inflation adjusted returns. Nominal returns, the percentage increase in the value of an investment, don’t tell how much the purchasing power of those returns has been diminished by rising prices. With inflation adjusted returns you see the real growth of wealth, how much the investment has gained or lost in value after accounting for inflation.

The importance of this adjustment in bringing a long term view of investment performance evaluation. Inflation gradually reduces the value of money, in that the same amount of money will not purchase as much in the future as it is today. Consider, for example, that an investment yields a 8 percent nominal return in a given year, but that the inflation of that year was 3 percent, so the inflation adjusted return is only 5 percent. It is a bit closer to the effect the investment really gives upon real purchasing power.

Inflation adjusted returns are crucial for long term investors — those who are planning on retirement or want to build wealth for a future goal. While neither of these goals is necessarily bad, just because an investment has not performed and expected does not mean that it is ‘bad.’ Aside from the occasional outlier, growing a portfolio over all time is very difficult to achieve, and investors may actually be overestimating the success of their portfolios if they aren’t accounting for inflation. It turns out focusing on how well investments keep pace with inflation and maintain real wealth over time, means considering inflation adjusted returns, rather than purely returns.

If you are comparing one investment option to another, understanding inflation adjusted returns also helps. Higher nominal return investments may or may not give better real return depending on the level of inflation. Inflation adjusted returns are therefore critical to objective, realistic thought in planning and managing one’s finances. 

Mechanics of Inflation Adjustment in Returns

To calculate inflation-adjusted returns, adjust the nominal return to account for lost purchasing power from inflation. This shows the real value of investment gains. First, find the nominal return, then adjust for inflation using the formula: 

For example, if an investment generated a nominal return of 7% over a year, and the inflation rate for that year was 3%, the real return would be:

Real Return = [(1 + 0.07) / (1 + 0.03)] – 1 = 0.0388 or 3.88%

This means that while the nominal return was 7%, the actual increase in purchasing power was only 3.88%. It shows that the real growth of an investment is different from nominal growth due to inflation.

This adjustment is important because inflation erodes the value of money. Without it, investors might mistakenly believe their wealth is growing faster than it actually is.

Inflation-adjusted returns reveal an investment’s true progress, allowing investors to better judge how their portfolios are performing against the overall economy. Consistently using this approach helps investors make more informed financial decisions and achieve real returns that match their long-term goals. 

From Nominal to Real: Understanding Returns

Nominal returns are just the actual reported returns on an investment without regard to the effect of inflation. If you have an investment that grew, it has grown a certain dimensionally – not a dollar amount. So this is a percentage increase in the value of an investment over a period. But nominal returns, which measure investment returns, don’t tell the whole story because they don’t reflect the power erosion from inflation.

Real returns, sometimes called inflation adjusted returns, go a step further in that they adjust for inflation. The result is that the degree to which an investment has grown in purchasing power is revealed, which provides a truer picture of the amount won or lost. For example if annual yield is 6%, but there is only 3% inflation for that year, an inflation adjusted (real) return would be around 3%. That means the investment went up in value but the investor’s ability to buy had only risen 3 per cent as inflation has eaten away at the real worth of the gains.

In a high inflation environment the difference between nominal and inflation adjusted returns becomes significant only over longer periods of time. Take, for example, when nominal returns appear strong on paper during unusually rapid periods of inflation, the real gain can be erased by inflation. That’s why investors who just worry about nominal returns may find themselves overestimating their investment performance while those looking at the inflation adjusted returns gives a more realistic picture of the way wealth is growing.

Investors can have a better understanding of the true performance of their investments by understanding nominal and real returns. Nominal returns help track growth, but what this means in real terms — in terms of real dollars in your pocket — is where you need to measure the real returns. 

Balancing Act: Inflation-Adjusted vs. Required Returns

Inflation adjusted returns play a central role in determining whether an investment passes the investors required rate of return test, the minimum return that justifies the investment’s risk. In the above case the required rate of return is often based on an investor’s financial goals, time horizon and risk tolerance. That sounds nice, but nominal returns could be ample enough, but inflation could erode that, requiring us to arbitrage investments with their inflation adjusted, or real returns.

To make sure that their portfolios are as much growing on paper as preserving purchasing power with the time, investors use inflation adjusted returns. For example, if an investor requires a required rate of return of 5% to meet their financial goals, on the other hand, with an annual nominal return of 6%, and 3% inflation, the inflation would adjust the return by 3%. Consequently, the investment falls short of the required return with inflation in mind, and is not that attractive for reaching long term objectives.

A major aspect of portfolio management is balancing required returns versus inflation adjusted returns. An investor should consider whether their historical rate of return on investments has consistently been a lower amount than the required rate of return, and alter their investment strategy, exposure to risk, or seek higher real growth potential assets. If returns from your investments are inflation adjusted and are greater (even if only slightly higher) than the rate of return you believe is essential to reach your aims then you can be more comfortable that your investment portfolio is working towards your goals.

Investors can then determine which investments are promising based on inflation adjusted returns vs required returns, resulting in a portfolio that creates real wealth and aligns to the investors financial targets. 

Practical Insight: Inflation-Adjusted Returns in Action

Here’s a simple example to explain inflation-adjusted returns: An investor puts $10,000 into an investment with an 8% nominal return, growing to $10,800 after a year. However, if inflation during that year is 3%, the real gain must be adjusted to reflect the true increase in value. 

First, the nominal return is 8%. Using the formula for calculating the real (inflation-adjusted) return:

Real Return = [(1 + Nominal Return) / (1 + Inflation Rate)] – 1

Plugging in the values:

Real Return = [(1 + 0.08) / (1 + 0.03)] – 1 = 0.0485 or 4.85%

In this example, the real return is 4.85%, meaning that while the nominal return was 8%, the investor’s purchasing power only increased by 4.85% due to inflation. The actual gain would be $485, not $800. 

This shows how inflation reduces nominal gains, highlighting the importance of using inflation-adjusted returns for a realistic view of financial growth. Without this, investors may overestimate their progress and make poor investment decisions. Factoring in inflation helps ensure accurate assessments and better long-term financial planning. 

Implications of Inflation-Adjusted Returns on Portfolio Strategy

Understanding inflation adjusted returns forms an important part of the overall modeling when it comes to portfolio management decisions and allocation of assets. If when investors fixate on nominal returns they forget about how lifting inflation gnaws away at your buying power over time. Investors, then, can prioritize inflation adjusted returns and more carefully consider their portfolios as themselves truly growing in real terms, as opposed to only on paper.

For example, another is that some asset classes (e.g., fixed income) may not return as much, in a given time frame, as they did in the past, especially in times of rising inflation. As inflation increases, bonds with fixed interest payments can become less attractive in terms of real value. Therefore, investors may move their portfolios into assets that have historically provided better protection against inflation, such as equities, real estate or TIPS (Treasury inflation protected securities). Generally, these assets yield returns that keep pace, or exceed, inflation, and thus will preserve your purchasing power.

At the same time, knowledge of inflation adjusted returns helps investors determine a more accurate risk / return profile of a portfolio. While a high nominal return may be the prettiest temptation, risk from a higher nominal return may be much more than the potential gain. Investors should focus on their returns instead of some fancy mathematical index and how it relates to the real return of their investments, which should reflect the investment’s risk and reward.

And using an inflation adjusted return makes a dynamic approach to portfolio management. When inflation trends change, investors may find that their strategies come a little out of whack when trying to maintain a good balance between risk, return and protection from inflation. In fact, by reviewing periodically the inflation adjusted performance, investors should be able to proactively make adjustments which effectively improve their ability to protect their portfolios from the ravages of inflation. 

Inflation Trends and Their Impact on Returns

Long term investment returns are dramatically impacted by inflation because it affects the real value of the asset and its purchasing power. Nominal returns, even for positive outcomes, may not materialize when real returns decline individually or even drastically. 

For example, in the late 1970s the U.S. experienced stagflation, where inflation exceeded 10%, and so bond and fixed income returns had essentially real values close to zero. Nominal returns did not change much, but in a time of high inflation the real value of aforementioned returns eroded, leaving many investors with negative inflation adjusted returns. 

The opposite is true when inflation is low and steady long-term investment returns have generally been more favorable. This means that since the gap between nominal and real returns is small, your compounding turns out to be preserving your purchasing power. This stability has historically given stronger real returns on equities and bonds: real gains were not eaten away by inflation in steps as dramatic as they were recently.

In fact, inflation has different effects on different asset classes. In an environment of moderate inflation, equities outperform because firms can raise prices to consumers in response to rising costs. However, fixed income assets are more susceptible to inflation because that type of asset pays out a predetermined interest with no adjustment for rising prices. The lower purchasing power of those fixed payments goes with rising inflation.

Overall, inflation trends are an important component of long term planning. With understanding of these trends, investors can adjust their asset allocation and strategy to fight back against the negative effects of inflation, and hence, real returns reach the investors financial goals. Investors can keep their portfolio balanced by watching the market and its history data for inflation, so that they may stay ahead of potential risks and stay ahead of the market. 

Adjusting Investment Strategies in High Inflation Periods

During times of rising inflation, investors are required to customize their strategy to avoid weighing their returns in real value. A good way to do this is to start shifting towards inflation resistant assets. Treasury Inflation-Protected Securities (TIPS) are investments that are designed to keep up with inflation since its principal value rises (or falls) in response to the changes in the Consumer Price Index (CPI). TIPS thus has appeal where purchasing power preservation is what you want in a high inflation environment.

Furthermore, equities can be an effective hedge against inflation, especially in sectors where companies can translate rising costs to consumers — such as consumer goods, energy, and utilities. These are usually sectors which tend to perform better during inflationary times because businesses in these sectors often have pricing power, therefore they can survive costs going up. Another asset class to protect against inflation is real estate. As inflation rises, property values, rental incomes, and certain bond options tend to rise too, giving you a little bit of a buffer against the atrophying effects of rising prices. 

There’s also diversification into commodities, another strategy for investors to consider. When inflation is rising, certain commodities — such as oil, precious metals like gold, and agricultural products — tend to grow in value, and they make up a key part of a portfolio if an inflation surge is on the horizon. Tools like the Commodity Channel Index (CCI) can help investors identify cyclical trends and make informed decisions when hedging against the bad effects of inflation on other asset classes, which can be done with commodity-linked investments or funds. 

Also under consideration is that fixed income investments, especially long term bonds, should be handled very carefully, especially when there is very high inflation — the longer in terms of fixed income, the higher the fixed rate of interest, the less the thought should be to invest in fixed income. Because bonds with shorter maturities or floating rate bonds adjust more quickly to higher interest rates (which frequently rise from inflation), they can afford to provide more protection.

Diversification into inflation-resistant assets and tweaking bond exposure buffers the real value of returns and supports a more dynamic portfolio through periods of inflation. You can also use investment tools like trading alerts to further bolster your strategy and reduce risk, ensuring timely adjustments that keep your portfolio resilient during changing market conditions. 

Conclusion

Not surprisingly, inflation adjusted returns are crucial to determining true performance of investment over time. Though nominal returns look appealing on the surface, inflation can eat away purchasing power unabated. Therefore it is important for investors to pay attention to this when computing returns. When investors focus on real returns they can better understand just how much their wealth is truly growing.

When inflation is high, actively managing a portfolio that incorporates inflation-adjusted returns can enhance strategy. Adjusting asset allocation to include inflation-resistant investments like TIPS, inflation-hedged equities, or commodities helps protect against falling value. Assuming nominal gains may be unstable with inflation changes, active portfolio management minimizes the risk of portfolios becoming vulnerable and experiencing large nominal gains without real value growth. 

The final form provides the information needed to adapt to an ever-changing economy and inflation-adjusted returns. Investors can make smarter choices regarding which investments to make and hold to preserve the long-term value of their wealth and continue meeting their financial goals by evaluating investments based on their true contribution to performance over the years. 

Understand Inflation Adjusted Return: FAQs

How Frequently Should Inflation Adjustments Be Made for Accurate Performance Analysis?

Annual inflation adjustments should be made to simplify the performance analysis, adjusting for changes in inflation and its effect on real returns. During times of high inflation or political or economic turmoil, knowing what the fund does now, and then seeing quarterly adjustments uplift the immediate impact on investments, can help in that process.

Can Inflation-Adjusted Returns Predict Future Inflation Impacts on Investments?

Returns in inflation adjusted form do not predict future trends but indicate how past inflation has distorted returns. They show the past of purchasing power erosion, yet need to be anticipated by economic forecasts and market indicators for future inflation impact.

What Tools Are Available for Investors to Easily Calculate Inflation-Adjusted Returns?

Financial calculators, Excel formulas and online inflation calculators from government sites or financial platforms can all be used by investors to help them calculate the effects of inflation. Real time assessment is made easier by many investment platforms that offer inflation adjusted performance metrics.

How Do Inflation-Adjusted Returns Differ in Fixed-Income Investments vs. Equity Investments?

Inflation is more of an enemy of fixed income investments, since fixed interest payments aren’t adjusted – so real returns end up diminished. Indeed, nominal returns of equity investments, especially in sectors able to pass on higher costs to consumers, appear to provide better inflation-adjusted returns compared to other assets primarily because they yield higher nominal returns.

What Are the Common Pitfalls in Interpreting Inflation-Adjusted Return Data?

The mistake most people make is incorrectly dismissing the difference between short-term inflation spikes and long-term trends. Additionally, investors can underestimate portfolio success by only considering nominal returns and ignoring the effect of inflation. One can also overestimate real returns by using outdated inflation rates or failing to account for the effects of continuous compounding.