Nominal Rate of Return
The total rate of return earned on an investment before adjusting for any deductions and premiums
What is the Nominal Rate of Return?
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 inflation. 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 services 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 fees, 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 trusts 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
CFI is the official provider of the Capital Markets & Securities Analyst (CMSA®) certification program, designed to transform anyone into a world-class financial analyst.
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:
