Nominal Rate of Return: Definition & Calculation

The nominal rate of return is the total rate of return earned on an investment before adjusting for any deductions and premiums, such as investment fees, trading costs, tax expenses, and inflationInflationInflation is an economic concept that refers to increases in the price level of goods over a set period of time. The rise in the price level signifies that the currency in a given economy loses purchasing power (i.e., less can be bought with the same amount of money).. It can be considered the “face” amount of a return.

Formula for the Nominal Rate of Return

Understanding the Nominal Rate of Return

A rate of return is the net gain or loss on an investment over a certain time period, usually expressed as a percentage of the initial investment.

The nominal rate of return is a simple rate of return metric that provides investors with an easily comparable percentage return on various investments. It is a simple metric since it strips out more complicated factors that affect performance, such as taxes and inflation.

Utilizing a nominal rate of return makes various investments with different time horizons and different associated inflation rates more comparable. Furthermore, investments with different tax treatments can be compared more easily with the nominal rate of return.

Practical Example

You’ve purchased 100 shares that cost $15 each. After exactly one year, the share price of each stock is $22. Assuming there are no dividends and no trading costs, what is the nominal rate of return?

Original Investment Price = $15 * 100 shares = $1,500

Current Investment Value = $22 * 100 shares = $2,200

So, (2,200/1,500) – 1 = 0.4667 or 46.67%

It can also be calculated using the share price of just a single stock.

Original Investment Price = $15/share

Current Investment Value = $22/share

So, (22/15) – 1 = 0.4667 or 46.67%

Nominal Rate of Return vs. Real Rate of Return

The nominal level of a return depends on the changes in the purchasing power of money. Adjusting the nominal rate of return by inflation will give the real rate of return, which is considered the actual increase in purchasing power.

Purchasing power can be thought of as the amount of goods and servicesProducts and ServicesA product is a tangible item that is put on the market for acquisition, attention, or consumption while a service is an intangible item, which arises from that can be purchased with a fixed amount of money. With steady inflation, you can expect purchasing power to decline over time as goods and services become more expensive.

Furthermore, the real rate of return may incorporate the tax rate that the investor is subject to. Adjusting the nominal rate of return for the taxation rate, the actual return that the investor receives is lower than the nominal rate.

Practical Example

You’ve invested in a security that yields a 10% return over exactly one year. The inflation over that same time period is 3%. Ignoring any trading feesTransaction CostsTransaction costs are costs incurred that don’t accrue to any participant of the transaction. They are sunk costs resulting from economic trade in a market. In economics, the theory of transaction costs is based on the assumption that people are influenced by competitive self-interest., taxes, or other expenses:

What is the nominal rate of return?

The nominal rate of return is simply 10% or the total return of the investment without considering inflation.

What is the real rate of return?

The real rate of return is 7% ( 10% – 3% ) which is the rate of return adjusted for inflation. In this example, your purchasing power has increased by 7%.

Now consider the same example, but now you are subject to a 20% tax rate on the investment.

What is the nominal rate of return?

The nominal rate of return is still 10%; it is the total return of the investment without considering inflation and taxes.

What is the real rate of return?

The real rate of return is now 5%; it is calculated as follows:

10% * (1 – 20%) = 8%, which is the after-tax return of the investment.

Adjusting for inflation, (8% – 3%), the real rate of return is 5%. In this example, your purchasing power increased by 5%.

The Issue with the Nominal Rate of Return

As mentioned earlier, the nominal rate of return is a simplistic rate of return used to compare investments. However, investors and decision-makers should be wary of using the nominal rate of return, as it does not accurately reflect the actual return that an investor will receive.

In making decisions, the nominal rate of return does not matter, investments should be evaluated and compared ultimately on the real rate of return and real risk premiums. Considering taxes, inflation, and other costs is important in determining the optimal investment.

For example, investment trustsReal Estate Investment Trust (REIT)A real estate investment trust (REIT) is an investment fund or security that invests in income-generating real estate properties. The fund is operated and owned by a company of shareholders who contribute money to invest in commercial properties, such as office and apartment buildings, warehouses, hospitals, shopping centers, student housing, hotels are investment vehicles that typically receive favorable tax treatments. If comparing the investment trusts’ nominal returns with other investments, it may appear to generate worse returns. However, in reality, the investment trust will yield a greater real return to investors.

More Resources

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In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• Annualized Rate of ReturnAnnualized Rate of ReturnAnnualized rate of return is a way of calculating investment returns on an annual basis. As we invest, we often want to know how much we are earning
• Nominal Interest RateNominal Interest RateNominal interest rate refers to the rate of interest before adjusting for inflation. It also refers to the rate specified in the loan contract without
• Purchasing Power ParityPurchasing Power ParityThe concept of Purchasing Power Parity (PPP) is a tool used to make multilateral comparisons between the national incomes and living standards
• Transaction CostsTransaction CostsTransaction costs are costs incurred that don’t accrue to any participant of the transaction. They are sunk costs resulting from economic trade in a market. In economics, the theory of transaction costs is based on the assumption that people are influenced by competitive self-interest.