How can the nominal rate of return help you evaluate investments?

The nominal rate of return is a straightforward way to measure the performance of an investment, showing the percentage gain or loss over a specific period. It offers a quick snapshot of total returns before accounting for factors like inflation, taxes, or fees, making it a valuable starting point for analyzing potential profits.

However, relying solely on the nominal rate can be misleading, as it doesn’t reflect an investment’s real value after adjusting for external factors. In this article, we’ll explain what the nominal rate of return is, how it’s calculated, and how to use it effectively alongside other metrics like the real rate of return.

Defining the Nominal Rate of Return

Nominal rate of return refers to the percentage gain or loss on an investment over a given period and not taking into consideration the other elements including inflation, taxation, charges or fees. It tracks the total income and appreciation produced, or dividends, interest, or capital gains, providing a raw, high-level picture of performance. Thanks to its simplicity, it’s often the best way to start responding to the question of whether an investment is growing.

Nominal rate is well known in finance to compare the performance of different assets or investments over a time period. For example, if an investor buys a stock for $1,000 and sells it a year later for $1,100, then the nominal rate of return on that investment was 10%. This simple calculation gives a precise absolute view of how much the investment has grown.

Measuring raw performance is useful however, the nominal rate doesn’t measure an investment’s true value over time. It removes the effect of inflation, which is eroding the purchasing power of returns, as well as taxes and fees that cut into actual profits. Due to this, it is an inappropriate measure of profitability for long term investments.

The nominal rate of return is then useful for looking at first order gains, but must be supplemented by other measures, like the real rate of return, to assess the net effect upon wealth. If investors take these factors into account, they stand in a better position to estimate their true financial outcomes.

Finally, the nominal rate of return works as a simple and fast measurement of the performance of investments, yet a careful inspection has to be done in order to pass by the external factors that impact real profitability.  

Insights from the Nominal Rate of Return

Nominal rate of return is helpful to know what percentage investment can return/gain/lose within a set period while neglecting the differences between before tax, after tax, before inflation, after inflation, before fee and after fee. Often used to compare investments or assess them in the short term, this raw metric gives a simple snapshot of how well an investment has really done in absolute terms.

For example, if an investment returned 7% nominal a year during the period, investors have a handy measure of success. However, in the absence of external factors — such as inflation — this measure can be misleading. If an investment does not keep up with inflation, the nominal rate is overstating an investment’s true growth since inflation has eroded purchasing power.

In order to do this, using the real rate of return, gives a more realistic picture because it discounts inflation. For instance, if inflation is 3% and the nominal return is 7%, the real return is around 4%, the increase in real value that can be achieved, after taking away lost purchasing power. When it comes to long term investments such as savings and pensions then this adjustment becomes especially significant – inflation can eat into your returns quite heavily.

The nominal rate of return has its place in assessing immediate gains, but fails to show the real economic benefit to the investor, over the long term. It is very important to understand either nominal or real rate of return in order to learn whether your investment is really profitable or is inflated due to external factors such as rising prices or currency devaluation.

Investors who are aware of the shortcomings of nominal returns and total them with actual rate ideas will probably make superior choices and better reveal the worth of their investments. 

Calculating the Nominal Rate of Return

The formula for calculating the nominal rate of return is relatively simple and is often used to determine the percentage change in the value of an investment over a specific period. The formula is:

Image of the nominal rate of return formula

This formula calculates the total percentage gain or loss on an investment, without adjusting for factors like inflation or taxes. Let’s break down each component with a simple example.

  • Beginning Value: This represents the initial value of the investment at the start of the period. For instance, if you buy a stock for $1,000, this amount would be your beginning value.
  • Ending Value: This is the value of the investment at the end of the period being measured. If the stock’s value increases to $1,100 by the end of the year, that is your ending value.
  • Difference (Ending Value – Beginning Value): This component calculates the total gain or loss during the period. In this example, the difference is $1,100 (ending value) minus $1,000 (beginning value), which equals $100.

Using the formula:

Nominal Rate of Return = [($1,100 – $1,000) / $1,000] × 100 = (100 / 1,000) × 100 = 10%

This means that the nominal rate of return for the year is 10%. This simple calculation provides the percentage return on your investment before any adjustments, such as inflation or taxes.

For another example, if the beginning value of an investment was $5,000 and the ending value was $6,000 after one year, the nominal rate of return would be:

Nominal Rate of Return = [($6,000 – $5,000) / $5,000] × 100 = 20%

This formula lets investors assess their investment’s absolute growth or loss, aiding comparison over time. However, it doesn’t consider factors affecting the return’s true value. 

Comparison: Nominal vs. After-Tax Rate of Return

Nominal rate of return and after tax rate of return are two important metrics for evaluating investment performance, each has its own use. The nominal rate is a raw increase or decrease on investment percentage over a time span without making any adjustments for inflation, tax or fee. It offers a simple view on the performance of an investment at face value.

Whereas, the before tax rate of return calculates the after tax income or gain on the investment. Since taxes can make such a dent in the actual return, this metric gives a more realistic picture of profitability by showing you what remains of the nominal return after taxes. 

​​For example, if an investment generates a nominal return of 8%, but the investor is in a 25% tax bracket, the after-tax rate of return would be reduced. The formula for the after-tax rate of return is:

Image of the formula for after tax of return

Using the 8% nominal return example and a 25% tax rate:

After-Tax Rate of Return = 8% × (1 – 0.25) = 8% × 0.75 = 6%

In this case, the investor would keep 6% of the original 8% return after taxes. 

The nominal rate is useful to compare raw performance of investments or periods, and is a quick indication of how much we have won or lost. But it is the after tax rate that matters when it comes to taking home profits, especially for investments that are subject to taxes on income, dividends, or capital gains. The importance of tax efficiency becomes even more salient in tax sensitive scenarios like managing retirement accounts or thinking about long term investment where tax efficiency matters in determining returns.

Both metrics are essential for well informed decision making. Even though the nominal rate is telling about the overall performance, the after tax rate is transparent about real retained profits which help investors to plan better.

Real-World Application

In the real world, the nominal rate of return suggests that an investor who buys shares in a renewable energy company, for example, First Solar, will make a specified rate of return. Let’s say the investor purchases 100 shares at $50 per share, for $5,000. In the coming year, with strong demand for solar panels and growth in new markets, the price of First Solar stock goes up to $60 per share and the total value of the shares to $6,000. In addition, the investor receives $200 in dividends during the year.

To calculate the nominal rate of return, we first determine the capital gain, the difference between the ending value and the initial investment:

Capital Gain = $6,000 (Ending Value) – $5,000 (Beginning Value) = $1,000.

Next, we add the dividends to the capital gain:

Total Return = $1,000 (Capital Gain) + $200 (Dividends) = $1,200.

Using the formula for the nominal rate of return:

Nominal Rate of Return = (Total Return / Beginning Value) × 100

Nominal Rate of Return = ($1,200 / $5,000) × 100 = 24%.

In this scenario, the investor’s nominal rate of return is 24%, reflecting gains from both stock price appreciation and dividend income.

Real world examples are shown of this metric. For one, Nvidia investors experienced gains due to the record setting rise in AI chip sales which their nominal returns reflect. But, rates that are nominal (or real) don’t include inflation, taxes, or fees. If you are investing in renewable energy or tech stocks, you have to know the difference between nominal and real rates of return to figure out what is an annual rate of return and how much wealth you are going to have in the long run. 

Benefits of Using the Nominal Rate of Return

Nominal rate of return is good, simple because it’s easy to use. It’s simple and easy to use and gives you a fast and reliable measure of an investment’s performance, allowing you to calculate how much your investment has increased or decreased over a specified period without having to account for things such as inflation or taxes. This tool is accessible enough for investors of all experience levels. 

It’s also another key benefit in allowing the comparisons of different investments. The rate of return can be consistently applied to stocks, bonds and portfolios. This uniformity allows investors to identify which assets or portfolios contribute the most to the overall return, which makes this data very useful for initial analyses and later for portfolio management.

The nominal rate of return is also helpful to evaluate short term gain or loss, as well. For example, this metric is the focus of investors with shorter time horizons—think day traders and active investors—who need to make real time decisions based on asset performance over days, weeks or months. Its simplicity allows you to evaluate and make decisions quickly, without the need to become a mathematician.

The main advantage of the nominal rate of return is that it is a simple, straight forward measure of performance, while the rate doesn’t consider inflation or other outside influences, which doesn’t make nominal return unimportant or useless. It concentrates on immediate gains and losses to help investors to effectively evaluate and compare opportunities and is a good tool in helping investors to make short term decisions and to analyse their portfolios. 

Limitations of the Nominal Rate of Return

The nominal rate of return is a helpful tool for judging the performance of an investment but it has some major drawbacks when it isn’t used in conjunction with other metrics. As a major drawback it does not consider inflation. As time passes, purchasing power is eroded by inflation, so a nominal return on an investment may eventually seem positive, but in real terms may be still flatlining, or even negative. In the case of long term investments, ignoring effects of inflation will give an incorrect impression of the expected wealth growth.

However, the nominal return rate also does not include taxes or transaction costs that can greatly reduce the actual profits. For example, the investor who earns a 10 percent nominal return may find himself with a quite lower net return, after taxes or fees on capital gains. Nominal rates can make an investment appear far too profitable by ignoring these costs, but this can be quite misleading.

It also does not face risk. Investments with the same nominal return may be different in reality, because one might have a higher risk associated. Investors may overlook the trade off between expected return and the amount of risk they are prepared to bear if not considering risk adjusted performance.

The nominal rate of return is a useful starting point, but such a metric should be complemented by metrics such as real rate of return, after tax returns, and risk adjusted measures in order to properly judge profitability, viability, and risk of the business. Investors can complement that by utilizing trading alerts, which can deliver timely notices and set the opportunity for them to refine their strategy. 

Understanding Inflation’s Impact 

The purchasing power of money earned from an investment is directly affected by inflation and so inflation plays a big role in how the nominal rate of return is interpreted. The nominal rate is the raw percentage gain or loss– it is not adjusted by inflation but over time inflation eats away the value of money. That’s why accounting for inflation is especially important for long term investments.

For instance, if an investment earns a nominal return of 6 percent, while the inflation rate for the same period is 3 percent, the real return (that is, the actual increase in purchasing power) is only 3 percent. This is calculated as:

Image of the formula for real rate of return

Sure, on the nominal return it may look good, but the real return shows you the real profitability of the investment. In effect, over long time horizons the effects of inflation compound and relying on nominal returns alone delivers a distorted view of growth.

Evaluating long-term investments requires a total understanding of the real rate of return, often referred to as the inflation-adjusted return, as it tells the true profitability after deducting inflation. Investors who ignore inflation may overestimate future investment values, especially when inflation is high. Real returns give a more accurate picture at least, giving investors a sense of whether their holdings are actually increasing in value. 

Nominal rate of return might be a simple measure of gains, but to have an idea of the real profitability there is a need to include inflation. Real returns are crucial for long term financial planning—for example, in order to see how well an investment will actually perform and how it will help you maintain and grow wealth over a prolonged period. 

Nominal Rate of Return in Portfolio Analysis

Nominal rate of return is another key underlying metric in portfolio analysis in portfolio analysis, which sets the foundational benchmark to measure a portfolio’s performance at the investment level. Nominal returns also allow investors to quickly determine the short term gain or loss of each asset, as it gives a clear shot in the dark on what the asset’s return has been in absolute terms. It is therefore very useful to compare different assets in a portfolio.

In broader analysis, the contribution of each asset to the portfolio performance can also be understood on the basis of nominal rate. Thus, for instance, if one asset has a nominal return of 10% and another has 5%, one can figure out the stronger-performing assets and reconfigure the asset allocation strategies accordingly. It further facilitates cross-asset class (e.g., stocks, bonds, mutual funds) comparison to see which segments are exhibiting the strongest returns. 

While useful for basic evaluation, the nominal return rate, however, is not adequate for a complete portfolio analysis. In addition, you have to consider inflation, taxes, fees, and risk. For instance, high nominal returns in a portfolio may not translate into real growth if inflation eats into purchasing power. Inflation-proofing investments is essential to ensure that returns maintain their real value over time. Taxes or transaction costs can be especially important, obliterating nominal gains; the key lesson is: it’s not the nominal return that matters, it’s what you end up with after all the taxes and transaction costs. 

The nominal rate of return provides a starting point for the purposes of judging short term performance of investments, compared to short term goals. It would be better to add it with other metrics, e.g. real return rate and risk adjusted returns, for more in depth analysis. It improves the ability to evaluate portfolio performance more accurately and allows for more balanced strategies tied to financial goals to last in the long run. 

Conclusion

The basic use of the nominal rate of return is to judge the raw performance of an investment, providing a fast and basic method for determining the gain or loss of an investment in a given time period. For short term comparisons and making decisions, it gives a very clear picture of how much an investment has grown in absolute terms. While the nominal rate is often considered, it is also often misleading if inflation and taxes are not accounted for.

When looking at long term investment strategies, the real rate of return must complement the nominal rate of return. Over time, inflation can reduce purchasing power and taxes or fees can lower profits, therefore it’s important for investors to pay attention to the figures behind the numbers. Including these elements allows investors to view their portfolio’s performance more accurately.

By taking into account the nominal rate of return, it becomes easier for investors to make decisions as it is encompassed by an elaborate analysis of risk, taxes and inflation. That is a good start and is crucial to making that important decision, but using multiple metrics makes sure that investments are not only working in nominal terms, but also adding real value to long term financial goals. 

Understand Nominal Rate of Return: FAQs

How Do You Distinguish Between Nominal and Real Rates of Return?

A nominal rate of return tells us the percentage yield of an investment without taking inflation, taxes, or any other external factors into account. Conversely, the real rate of return takes the nominal return and adjusts it to account for inflation, and therefore gives a more honest picture of the investment’s purchasing power growth. When assessing returns, investors often compare them to their required rate of return, which represents the minimum return needed to justify the risk of the investment. The real rate of return allows investors to see how much inherent value they have actually gained after having subtracted out the soul-consuming power of inflation. 

What Are the Typical Uses of the Nominal Rate of Return in Financial Planning?

The nominal rate of return is the usual rate used to measure short term investment performance and to compare returns from different assets or investment strategies. This is a very simple metric that will tell you immediately how successful an investment was over a particular time frame. It is used by financial planners often to evaluate and rank different investments, though usually that’s just the beginning of a deeper analysis.

Can the Nominal Rate of Return Mislead Investors About the True Growth of Their Investments?

Yes, the nominal rate of return may be misleading, if taken out of context. This excludes inflation, taxes and fees all of which can dramatically cut the actual value of the returns. Take a high nominal return, say 20 percent: That actually doesn’t mean much in real gains of purchasing power or net profits after you take external factors into account.

How Does Inflation Affect the Relevance of the Nominal Rate of Return?

The purchasing power of money gets eroded by inflation which means that even though an investment may have a positive nominal return, its real return may not have been as good as it looks. In the case of long term investments the nominal rate of return can be greatly degraded by inflation, which makes it necessary to take into account the real rate of return representing actual wealth growth.

Why Is It Important to Consider Both Nominal and Real Returns When Assessing Portfolio Performance?

Nominal and real returns are taken into account in order to have a complete investment performance picture. Nominal returns simply give us the raw growth, but real returns give us the true increase in purchasing power after inflation. Both of these items are important to assess, especially for long term goals where inflation can materially reduce what you get back from the returns.