|Returns are about money. Real returns
are about value. Plan for real returns.
Real returns and nominal
If you earn interest of 4% on a cash account, that is called the
'nominal' return, or 'money' return, or 'cash' return. But you don't
want money. You want what money will buy.
The change in what money will buy is measured
by inflation. If inflation over the same period is 3% you need £103
at the end of the year to buy £100 worth of goods in 'old money'.
In terms of spending power you have earned just £1 in 'new money'.
This is your 'real' return. It is about equal
to the nominal return minus inflation (4% minus 3%, or 1%). Because
of compounding this is not quite true, but near enough. The precise
real return is 1/103, or 0.97%.
The message is......
It is real returns that matter.
For any investment, get used to adding the income
return to the capital gain and subtracting inflation to get the
real total return. Always question whether any quoted returns are
real or nominal.
Some investments are more inflation-proof than
others. Their nominal returns tend to go up as inflation increases
so that their real returns stay the same.
But that is another story.