The difference between nominal return and purchasing power

When an investment earns 10% in a year, it sounds like good news. But if prices rose 12% in the same period, you can buy less than before. The difference between what the money earned in numbers and what it can buy is the difference between nominal return and purchasing power.

The concepts

• Nominal return. The change in value in currency, without considering the change in prices. It is the one usually advertised.
• Inflation. The general rise in prices over a period, measured by official indexes.
• Real return. The return after inflation is deducted. It shows the change in purchasing power.
• Purchasing power. The quantity of goods and services you can buy with a certain amount.

Criteria for comparison

1. Compare over the same period. The return and the inflation must be from the same interval.
2. Use an appropriate index. Different indexes measure different consumption baskets; choose the one closest to your spending.
3. Consider costs and taxes. They reduce the nominal return before you talk about real.
4. Watch the term. Small effects each year add up over many years.

Ways to interpret it

One way to summarize: if the nominal return is higher than inflation, purchasing power rose; if equal, it stayed stable; if lower, it fell. The exact calculation is: (1 plus nominal return) divided by (1 plus inflation), minus 1.

An example

You have 10,000 and, after a year, the value rises to 11,000, a nominal return of 10%. If the year's inflation was 4%, the real return is about 5.8% (1.10 divided by 1.04, minus 1). Your purchasing power rose. If inflation had been 12%, the real return would be negative, about minus 1.8%: you would have more money but buy less. The numbers are illustrative.

Pros and limits of this analysis

Pros: shows whether money is really growing and helps compare options fairly. Limits: the inflation each person feels can differ from the index, and past results do not guarantee future ones.

Decision

When evaluating any investment or income increase, ask: "is this nominal or real?". The same applies to salary and rent adjustments. This text is educational and is not investment advice.