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Inflation Adjusted Returns

Investors often focus on nominal returns when evaluating investment performance, but this approach can be misleading due to the erosive effect of inflation on purchasing power. Inflation adjusted returns take into account the impact of inflation on the purchasing power of money over time, providing a more accurate picture of an investment's true value.

The Impact of Inflation on Investment Returns​

When we say that an investment has returned 10% over a given period, what does that really mean? If inflation was 5% during the same time frame, then the purchasing power of our money has actually decreased by 5%. As a result, the true return on our investment is only 5%, as measured in terms of purchasing power. This is where inflation adjusted returns come into play.

How Inflation Adjusted Returns Work​

To calculate inflation adjusted returns, we need to account for the difference between nominal and real returns. The process typically involves using an inflation index (such as the Consumer Price Index or CPI) to adjust the investment return for the impact of inflation. This can be done in various ways, including:

Using Historical Inflation Data​

This method involves looking up the inflation rate for each year during the investment period and applying it to the investment return.

Pros: Simple, easy to understand; Cons: Assumes consistent inflation rates.​

Employing a Real Return Calculator​

This approach uses a pre-existing calculator or tool that takes into account the average annual inflation rate over the investment period.

Pros: Quick and efficient; Cons: May not accurately reflect individual circumstances.​

Investing Strategies with Inflation Adjusted Returns in Mind​

In today's low-inflation environment, investors might be tempted to overlook the importance of adjusting returns for inflation. However, history shows that higher inflation periods can occur suddenly and without warning, leaving investors unprepared if they're relying solely on nominal returns. A prudent approach is to always consider inflation adjusted returns when evaluating investment opportunities.

Investing in Inflation-Resilient Assets​

Certain assets are less susceptible to the negative effects of inflation, such as precious metals (e.g., gold), real estate, and dividend-paying stocks.

Pros: Can provide hedge against inflation; Cons: Typically come with higher price tags or trade-offs.​

The Bottom Line on Inflation Adjusted Returns​

In conclusion, inflation adjusted returns offer a more accurate picture of an investment's performance over time. By understanding the impact of inflation on our money and using tools to adjust for it, we can make more informed decisions about how to grow our wealth in line with our goals.

Final Considerations​

When evaluating investments or retirement accounts, consider calculating your actual returns after adjusting for inflation. This may help you identify areas where your portfolio could be better optimized to withstand future periods of higher inflation.