FP Answers: What’s the difference between nominal and real returns and why does it matter?

As seen in Financial Post: FP Answers on December 8, 2023

Q: What is the difference between nominal and real return for an investment portfolio and why does it matter?

A: Inflation in Canada has come down considerably from the highs in 2022 when it peaked at 8.1 per cent in June, but it remains higher than the long-term target of 2 per cent. The Bank of Canada projects it will hover around 3 per cent before coming back down to the 2 per cent target by mid-2025. Though the numbers may seem small, even mild inflation can make a big difference to investors and consumers. Consider that the same basket of goods that cost $100 in 2000 would cost $165.00 in 2023, and this during a 23-year period of tepid inflation averaging 2.2 annually. Investors need to understand the difference between nominal and real returns to gauge how well their investments are truly performing in protecting their buying power.

Simply put, a nominal return is the total rate of return on an investment before deducting inflation, taxes, trading costs, and investment fees. What remains after these deductions is the real return on the investment which represents actual purchasing power. Except in such circumstances as deflation (negative inflation), or zero inflation, the nominal return will always be higher than the real return. Using nominal returns is a convenient method for comparing the returns of various investments, without having to adjust for different levels of taxation or fees.

In the developed world, inflationary forces include changing demographics, shrinking working-age population, higher wages and healthcare costs, geopolitical strife increasing spending on defense, the onshoring of manufacturing, and higher charges related to reducing greenhouse gas emissions. For investors, protecting buying power from the corrosive effects of inflation is an important goal.

Historically, bonds are the most sensitive to rising inflation and interest rates as both the value of the principal and the fixed interest payments are eroded when the bond is held to maturity. In addition, because bond prices move inversely to bond yields, with longer-dated maturities being more sensitive to changes in yields than shorter-dated maturities, higher yields cause bond prices to fall. (However, bonds with higher yields will provide higher interest payments which may compensate investors somewhat for the drop in price.) Inflation-linked government bonds (called TIPS in the US, real return bonds in Canada) that track real inflation rates benefit investors in a rising rate environment but have not performed well because real rates have repriced by about 200-250bp for RRBs which is not far from the increase in nominal yields.

Equities are less affected by high inflation because their value is primarily derived from business earnings which may increase if prices are rising due to inflation. Over a very long period, from 1900-2022, they have posted positive real returns of 5 per cent. However, while corporate earnings benefit from inflation, there is significant room for multiples to compress over time as equity risk premiums are historically low.  Starting points matter, if you had bought the S&P 500 in March 2000, a decade later your return would have been negative in nominal terms.

During 2022, the S&P 500 Index fell 18 per cent in nominal terms but to recoup the loss in real terms, it would need to rise more than 30 per cent. The global aggregate bond index dropped 16 per cent. It was a tough year for investors who had a typical balanced fund of 60/40, equities/bonds. Given stretched valuations going into the year, it could be a long time before investors recoup their losses in either real or nominal terms.

Where can investors reliably expect to find real returns? Historically real assets like real estate, timber and infrastructure served as an inflation hedge. However, historical relationships might not be the best guide to forward returns as private market valuations are anchored to exceptionally low discount rates and have been slow to adjust to the new reality of higher rates. Comparisons to the 1970s are challenged by a different demographic set up this time. Baby Boomers entering their peak consumption years supported high multiple stocks growing into their valuations in the most recent episode of higher inflation.  

Another option is to consider active asset management. The bull market of the past 20 years rewarded passive investors, however, in this new cycle of greater volatility, uncertainty, and higher-than-average inflation, active management and alternative strategies may become an important source of generating meaningful, positive real returns. For example, the Pender Alternative Absolute Return Fund which I generate research for is a low-risk alternative credit strategy that aims to produce absolute positive returns at all stages of the economic cycle. It has a low correlation to both traditional equity and fixed-income investments. These are the types of flexible strategies investor may wish to add to their portfolios with the goal of providing diversification and the opportunity to earn real returns in unpredictable markets.

Rachel Zhang, CFA, FRM
Investment Analyst, Pender