The nominal rate of return shows the yield of an investment over time without accounting for negative elements such as inflation or taxes. By calculating the nominal rate of return, you can compare the performance of your assets easily, regardless of the inflation rate or differing spans of time for each investment. By obtaining a bird’s-eye view of how your assets are growing, you can make more prudent investment decisions in the future.
For more help – objectively – evaluating investment options, consider working with a financial advisor.
How to Calculate the Nominal Rate of Return
Using the following formula, we can calculate the nominal rate of return:
Nominal rate of return = Current Investment Value/Original Investment Value – 1.
For example, suppose an investor puts $50,000 into a mutual fund. After a year passes, the account grows to a total of $55,000. The current investment value is $55,000, and the original investment value was $50,000.
55,000/50,000 – 1 = 0.1 (0.1 x 100)
Therefore, the nominal rate of return for this investment is 10% (0.1 x 100).
Nominal Rate of Return vs. Real Rate of Return
The nominal rate of return gives the investor a cursory look at their investments, but it doesn’t account for specific impacts on the value of each investment. So, to get a clearer idea of the returns your investments are giving you, the real rate of return can help.
The real rate of return modifies the value of an investment by applying the inflation rate in its calculation. Using the previous example with the mutual fund, let’s say the inflation rate during the year was 2%. By subtracting the inflation rate from the nominal rate of return, we get a real rate of return of 8%.
By including the inflation rate, the investor can see the real rate of return, which gives them a better idea of how far their money will spend in the present financial climate.
Nominal Rate of Return vs. After-Tax Rate of Return
We can further determine an investment’s performance using the after-tax rate of return. As the name implies, this calculation applies the taxes imposed on an investment.
How much tax is taken from an investment’s financial growth is based on several factors including:
- The investor’s tax bracket
- How long ago the investor acquired the asset
- What type of asset it is
Therefore, different investors may receive different rates of return on the same investment based on their tax situations.
The nominal rate of return can obscure the actual performance of investments since taxation varies among different investments. For example, federal government bonds are usually exempt from state and local taxes. On the other hand, municipal bonds are often exempt from federal and state taxes. That said, it’s worth calculating the after-tax rate of return on such assets since these tax-free bonds can outperform other investments that appear to give great returns but are also heavily taxed.
Understanding the Limits of the Nominal Rate of Return
When comparing the nominal rate of return versus the real rate of return and after-tax rate of return, the nominal rate of return is often not specific enough. It may not provide enough information to illustrate the performance of a particular investment.
Because taxes and inflation are always in play, the nominal rate of return will always be a general number. An investment that yields average returns but is lightly taxed or not taxed at all can be better than an asset that has a higher nominal rate of return but is dinged with federal and state taxes before the returns reach your pocket.
When making decisions, investors should look at the real rate of return and the nominal rate of return. For example, suppose recent inflation is hurting investments in the short-term. In this case, measuring the nominal rate of return over an extended period can help an investor see if an asset is suffering a temporary setback or has not been performing well compared to other investments.
The Bottom Line
The nominal rate of return is a straightforward calculation that provides an idea of how investments perform over time. Investors can rapidly compare the nominal rate of return of a spread of assets to sort out which ones provide the most growth. However, the nominal rate of return is not definitive. Varying degrees of taxation affect the gains of most investments. This means that the after-tax rate of return more realistically reflects the yield the investor will receive.
Another factor especially relevant currently is inflation, which reduces the rate of return as well. Calculated together, taxes and inflation provide specific, reliable figures for how well investments are doing. That said, when determining the rate of return for investments, it’s best to look at the nominal rate of return and the real rate of return jointly.
Tips for Investing
- A financial advisor can help you calculate the expected return on the investments you are currently considering. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re looking for a way to see how your investments will grow given a certain rate of return, try SmartAsset’s investment calculator.
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