Let’s say you have £1,000 pounds and you want to save it towards a purchase that you plan to make in a year’s time. The best savings account you can find offers an interest rate of 3%. So your £1,000 pounds will grow into £1,030 pounds in a year’s time. Is that good or bad? The answer is, we don’t know.
That 3% interest rate is the “nominal” return on your savings. What we need to know is the “real” return. That is, your return after inflation is taken into account. This matters because inflation reduces the value of a future sum of money.
If your cost of living – that is, the prices of the goods and services that you use regularly – rises more rapidly than the value of your savings, then by the end of the year, your purchasing power will have fallen. You might have more money in nominal terms, but you won’t be able to buy as much with it. In other words, its value will have fallen in real terms.
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Calculating the real return is simple. You just subtract the inflation rate from the interest rate (or expected return, if we’re talking about investments). So if inflation is running at 1% and your savings account is paying 3%, your real return is 2%. Your savings have increased in value. But if inflation is running at 5%, your real return would be minus 2%. So in real terms, you’ve lost money. You might have £1,030 pounds in your pocket – but it buys you less than the £1,000 pounds you started with a year ago.
Of course, measuring inflation is tricky. Everyone’s cost of living differs, depending on what they buy. And asset prices – including most significantly, house prices – do not feature in the official inflation gauge, the Consumer Prices Index. But that’s a topic for another day. To learn more about how inflation affects your investment portfolio, read MoneyWeek magazine – sign up here if you haven't already done so.
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