To help investors gauge the performance of their portfolio which could be comprised of stocks, bonds, cryptocurrencies or more physical investments such as property, they calculate the nominal rate of return.
This metric strips out the outside factors that may influence performance such as taxes or inflation.
The nominal rate of return is defined as “the amount of money generated by an investment before factoring in expenses such as taxes, investment fees and inflation”.
For example, if an investment produced a 10% return, the nominal rate would be equal to 10%.
You may have heard of this term but aren’t sure what it means.
A lot of technical jargon tends to go over our heads, when in reality the terms are very simple and easy to understand.
In this article we will explain more about what the nominal rate of return is, how it’s calculated and understanding how it’s used.
Calculating The Nominal Rate Of Return
To calculate the nominal rate of return, use this simple formula:
Nominal Rate Of Return = Current Market Value – Original Investment Value
Original Investment Price
- Firstly, subtract the original investment value from the current market value of the investment or asset
- Use the result from numerator (the top part of the equation) and divide it by the original investment amount
- Finally, multiply the result by 100 to turn the nominal rate of return into a more useable percentage figure
So, What Does This Mean?
Rate of return simply means how much is lost or gained on an investment over a certain time period.
The nominal rate of return provides investors with comparable data, usually presented in percentages, on their various investments.
Comparing their investments is important as they can cut ties with certain assets that aren’t appreciating in value.
This data can be utilized to compare various investments with different time horizons and associated inflation rates.
Additionally, you can compare investments with different tax treatments easily using the nominal rate of return.
Tracking the nominal rate of return is important when managing portfolios or components in the portfolio as investors can see how their investments are changing over time.
Nominal Rate Of Return Vs Real Rate Of Return
The real rate of return refers to the annual return taken into consideration after taxes and inflation are accounted for.
Investors will receive the real rate of return after making an investment.
Taking inflation and taxes into account is important to demonstrate whether or not the investment will be worth it if you’re comparing it against other opportunities.
As the nominal rate of return doesn’t account for specific factors, it is important to consider the real rate of return when evaluating the performance of an investment.
This can give you a clearer picture of how far your money will go in the present financial climate.
The real rate of return can also be calculated using a simple formula:
Real Rate Of Return = Nominal Interest Rate (%) – Inflation Rate (%)
Nominal Rate Of Return Vs. After-Tax Rate Of Return
The after-tax rate of return is as the name suggests, the calculation of the taxes imposed on an investment (see also ‘How To Calculate Net Investment‘).
Sometimes further calculations such as this are needed in order to determine an investment’s performance.
How much tax is deducted from an investment’s financial growth is based on multiple factors such as the investor’s tax bracket, the period of time the investor has owned the asset and what that asset actually is.
As a result, different people may receive different rates of return on the same investment dependent on their tax situations.
Calculating just the nominal rate of return means that the performance of the investments can be obscured since the taxation varies among different investments.
Therefore, calculating the after-tax rate of return can be worthwhile on assets such as those that are exempt from taxation as they can outperform other investments that appear to give a great return but are also heavily taxed.
Limitations Of The Nominal Rate Of Return
As previously mentioned, the nominal rate of return calculation doesn’t account for inflation or taxes when looking at the performance of an investment.
Therefore it can be misleading and is also considered to be a simplistic metric.
To demonstrate, an investment that earned 10% over one year, but inflation was 2% across the same period, the actual rate of return would be 8%.
Although the nominal rate of return is an important figure to consider when comparing the performance of many investments, it should be used alongside other figures such as the real rate of return, knowledge of current tax costs and inflation to determine whether the potential investment gains are not being reduced by inflation or rising prices.
For example, corporate bonds are taxed at 30% whereas municipal bonds are exempt from taxation.
If an investor holds both types of bond with a nominal value of $10,000 and an expected nominal rate of 10%, they may assume the bonds are of equal value.
In reality the real rates of return are completely different due to the taxation requirements.
Final Thoughts
The nominal rate of return is the amount of money that is generated by an investment, without accounting for factors such as taxes, inflation and investment fees. This metric is useful for investors to assess the performance of their investments over time.
We hope you found this article interesting and informative, you should now have a clearer understanding of what the nominal rate of return is, how it’s calculated and how it is used in regard to investment decisions.
Frequently Asked Questions
What Is The Difference Between Nominal And Real Rate Of Return?
Understanding the difference between the nominal and real rate of return is very simple.
The difference is that nominal rates do not account for inflation or taxes whereas real rates of return do account these external factors.
As a result, nominal rates are usually higher and more appealing than real return rates.
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