Real vs. nominal return

The nominal return is the figure your bank or broker shows you. The investment made 7%, that is the nominal return.

The real return is what is left of it once you allow for everything else having got more expensive in the meantime. And it is this figure that decides whether you are genuinely better off.

Why 7% on its own is not enough

Money is not the goal in itself: the goal is what you buy with it. If your savings grow by 7% but bread, rent and petrol all rise by 3%, you have gained only the difference.

In the extreme this can be zero or less. A savings account paying 2% while inflation runs at 3% looks like a gain, but in truth you are one percent poorer every year. Nominally you are rising, in real terms you are falling.

How to work it out

For a quick estimate, subtraction is enough:

$$\text{real return} \approx \text{nominal return} - \text{inflation}$$

So 7% − 3% ≈ 4%. For everyday decisions that is perfectly sufficient.

The exact calculation is a ratio, not a difference:

$$r_{real} = \frac{1 + r_{nominal}}{1 + \pi} - 1$$

Where $\pi$ is inflation as a decimal. At 7% and 3% that gives 3.88% rather than the estimated 4%. The gap is small, but it grows when inflation is high, and that is when it is worth calculating exactly.

What it means in practice

This distinction changes how you look at most financial decisions:

When saving it tells you whether the account keeps pace with prices at all. Most ordinary accounts do not.

When investing, the real return is the only honest measure. The historical return of equity markets of around 7% is nominal: in real terms it is closer to 5%.

With a mortgage, inflation works the other way, in your favour. The instalment stays the same, but its real weight in your budget falls over time.

For long-term plans it is essential. A sum that looks large thirty years out may not be enough.

Try it yourself

In the compound interest calculator you can switch on the inflation adjustment and see the nominal and the real value side by side. In the FIRE calculator the real return is worked out automatically.