1.1.5 Nominal vs Real Returns

Two numbers, one often hidden

A fixed deposit advertising 7% is quoting a nominal return: the stated percentage, with no adjustment for anything. If inflation over the same period runs at 5%, the real return, the part that actually increases what you can buy, is only about 2%. The nominal figure is what's printed on the brochure. The real figure is what matters to your standard of living.

This gap is easy to miss because nominal returns are the only number most products advertise. Nobody puts the real return on a poster, even though it is the only one that answers the question am I actually getting wealthier?

The approximation is simple: real return is roughly nominal return minus inflation. A more precise version is the Fisher relationship, (1 + nominal) divided by (1 + inflation), minus 1, but the subtraction is close enough for most decisions. What matters is building the habit of mentally subtracting inflation every time a return figure is quoted.

Comparing across asset classes

The gap between nominal and real returns varies by asset class and by period. A very safe instrument can have a nominal return that barely clears inflation, leaving a real return close to zero, while a growth asset with a higher nominal return can still leave meaningfully more in real terms even after the same inflation is subtracted.

Tax widens the gap further. Fixed deposit interest is taxed at slab rate, so a 7% FD in the 30% bracket yields about 4.9% after tax; subtract 5% inflation and the real after-tax return is roughly zero. Equity long-term gains are taxed at 12.5% above a ₹1.25 lakh annual exemption, so a 12% nominal equity return can leave a real after-tax return of 5-6%. The tax structure alone creates a large gap in real wealth creation, before any difference in nominal return is considered.

The number to anchor on

When comparing two investments, or judging whether a goal is on track, the real return is the one worth anchoring on. A portfolio can show a healthy nominal number every year and still be quietly failing to build wealth, if inflation has been eating most of the gain the whole time.

A useful check is to take your portfolio's overall XIRR and subtract a conservative inflation estimate. If the result is under 2-3%, the portfolio is barely growing in real terms despite a healthy-looking nominal figure. Goal projections should be done the same way: a ₹50 lakh goal in today's money, fifteen years out at 6% inflation, is really a ₹1.2 crore target, and planning against the un-inflated number guarantees a shortfall when the goal arrives.