Real vs nominal returns

A nominal return is the number a fund quotes: the percentage change in the dollar value of your investment. A real return subtracts inflation, leaving the change in what that investment can actually buy. Every long-horizon financial decision depends on the second number, and almost every tool reports only the first.

The arithmetic

The approximation most people use is to subtract: 7% nominal minus 3% inflation gives roughly 4% real. That is close enough for mental arithmetic at low rates. The exact relationship, called the Fisher equation, is a ratio rather than a difference:

real = (1 + nominal) / (1 + inflation) − 1

At 7% and 3% the exact answer is 3.88%, not 4%. The gap between the shortcut and the exact figure is small at low rates and grows at high ones — at 12% nominal and 9% inflation the shortcut says 3% and the truth is 2.75%. Over decades, that difference compounds into real money.

Why the gap widens with time

Both the return and inflation compound, so the divergence between the nominal and real paths is not linear — it opens up faster and faster. A 30-year projection at 2.5% inflation ends with a real value roughly 52% of the nominal one. At 3.5% it is about 36%.

Purchasing power of one nominal dollar after the stated period, computed as 1 / (1 + inflation)^years.

Where this changes decisions

Retirement targets

A projection of "$1.5 million at 65" means nothing until you know which dollars. If that is nominal and you are 30 years out, you are planning a retirement funded by something closer to $620,000 of today's money. Most people who see both numbers revise their savings rate.

Cash holdings

A savings account paying 4% while inflation runs at 3% earns a real return under 1%. A savings account paying 0.5% in the same environment is losing about 2.4% a year in purchasing power, with perfect nominal safety. The account statement will never show a loss.

Bond yields

The quoted yield on a bond is nominal. The real yield is what you keep. Treasury Inflation- Protected Securities exist precisely because the distinction matters enough to build a separate instrument around it, and the spread between nominal Treasury yields and TIPS yields of the same maturity is a market estimate of expected inflation.

Salary

A 3% raise in a 3% inflation year is not a raise. It is a hold. This is the same arithmetic applied to income rather than to assets, and it is the reason a contribution to a retirement plan that never rises is quietly shrinking every year.

Which inflation rate should you use?

The honest answer is that nobody knows the future rate, so the useful move is to test a range rather than pick a point. Run your plan at 2%, at 3%, and at 4%. If it only survives the lowest of those, it is not a plan, it is a hope.

Bear in mind too that published CPI measures a basket meant to represent an average urban household. If your spending is concentrated in categories that have run hotter than the headline — rent, healthcare, childcare, education — your personal rate is higher than the official one, and your plan needs more margin than the statistic suggests.