Article / 12 February 2016 at 13:11 GMT

Only real rates are the real thing

  • Return rates are usually disclosed as nominal values
  • When calculating future purchasing power the real rate is decisive
  • Inflation and the nominal rate are decisive for the total real rate of return
  • Average inflation over the last 25 years has been close to, but below the 2% target 
  • 10% nominal return needed for 8% real return with German inflation
Bundesbank
Just can't get enough of the view of the Bundesbank HQ? Here it is again. Photo: Bundesbank

By Clemens Bomsdorf

When looking at the performance of an investment, the real rate of return is crucial. In the long run inflation is a factor that can eat a decent part of an investment's profit. After all, inflation is like (negative) compound interest (read my earlier piece on financial literacy here, which explains the concept of compound interest). When investing for the long term – such as for retirement – it is important to be aware of the effect of compound interest.

The inflation rate is a decisive factor when calculating the nominal return as well as the investment needed to accumulate enough wealth to maintain today’s purchasing power when no longer working. (The other factor is of course the nominal rate of return).

After having investigated the nominal performance of stock markets over periods of 25 years in a previous article (How equities can make for blockbuster long-term returns) we will now use inflation rates to calculate real rates of return.

Penny Markt
As lively as the Bundesbank HQ: A Penny supermarket in Berlin. 
Consumer prices set at places like this are decisive for inflation. Photo: iStock 

In the previous article we discussed two almost equal 25-year periods for the performance of the  Eurostoxx and Dax – and found an average annual 8.5% nominal rate of return. For the Dax, the period under investigation was the 25 years ending last December while for the Eurostoxx it was the period ending a year earlier (and the performance for the same period as the Dax was 8.4%, i.e. almost equal).

Let’s have a look at what the real return for an average nominal annual return of 8.5% was over that period. Note that in the following all figures are rounded to one decimal point. Also note that due to the CPI statistics published values are not always taken for full years (see below), but the difference is minor. 

Inflation fluctuates and this should be mirrored in our calculations. At the same time when looking ahead it would be good to have a fixed rate that can be applied. Since we earlier focused on Europe’s largest economy, Germany, we are applying its historic inflation rate to the nominal rate.

DEinflation
 
A fixed inflation rate of 2% is used as it is a very common inflation target (used for example by the ECB as outlined here). 

Looking at the past 25 years we can see that on average these two rates do not differ that much – Germany came in with 1.8% (based on the German CPI December values, but starting with January 1991 since this is the oldest available, Source: German Statistical Office). In some years inflation was much higher than 2% and in other years much lower (as right now). The same goes for the Eurozone (see chart below and above).

EMU Inflation
 
The chart below shows what these two different rates of inflation did to our 8.5% nominal annual rate of return over time. Note that the fluctuation in the German inflation rate is accounted for. Though German inflation on average has been lower than 2% this was not the case every year.
Therefore in some years the real return was higher with the German inflation rate applied than with the EMU’s 2% target and some years it was the other way around.

Impact Inflation
 
The table below shows the impact of the two different average inflation rates on the nominal rates of return from previous articles.
 
The data underlines what a nominal rate below inflation does to savings in the longer term. We have used the above mentioned inflation rates; in principal this also holds for today's situation. Inflation is below 1% now, but so are interest rates (if banks pay them at all).  

Table Inflation rates
 
What we can see here is that with the historic German inflation rate, a nominal real rate of return of roughly 10% was needed to reach an average annual real rate of return of 8% – as according to Bundesbank this is what German savers made from their stock investments over the 24 years ending December (again, note the slight difference in investigated time, but that does not change much).

This article is meant to illustrate the effects of inflation, which while most investors and traders are aware of, those making only a few and more strategic investments (such as saving for retirement) may sometimes underestimate.

– Edited by Gayle Bryant

Clemens Bomsdorf is a consultant editor at TradingFloor.com

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