Nominal rate of return
| Nominal rate of return |
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Nominal rate of return is an investment performance measure that expresses the rate of return on an investment in nominal, or current, dollars. It is the return on an investment that does not take into account the effects of inflation or purchasing power. It is the percentage change in the value of the investment over a given time period, such as one year. It is calculated by comparing the beginning and ending values of the investment and dividing this change by the beginning value. Nominal rate of return is often used to compare the performance of different investments over different time periods.
Example of nominal rate of return
- If an investor invests $10,000 in a portfolio and at the end of one year the portfolio is worth $11,000, then the nominal rate of return would be 10%. ($11,000 - $10,000) / $10,000 = 10%.
- For example, if you buy a bond that pays $90 in interest and has a face value of $1,000, the nominal rate of return is 9%, ($90/$1000=9%).
- If an investor invests $100,000 in a portfolio and at the end of one year the portfolio is worth $110,000, then the nominal rate of return would be 10%. ($110,000 - $100,000) / $100,000 = 10%.
Formula of nominal rate of return
The formula for calculating nominal rate of return is given by:
Nominal Rate of Return (NRR) = (Current Value – Original Value) / Original Value
NRR = (CV – OV) / OV
Where,
NRR = Nominal Rate of Return
CV = Current Value
OV = Original Value
This formula is used to calculate the return on an investment in nominal, or current, dollars. It is the percentage change in the value of an investment over a given time period, such as one year. This formula is used to compare the performance of different investments over different time periods.
For example, if you invest $10,000 in a stock and the current value is $12,000 after one year, the nominal rate of return can be calculated as:
NRR = (12,000 – 10,000) / 10,000
NRR = 0.2 or 20%
This means that the investment returned a 20% rate of return in nominal, or current, dollars.
When to use nominal rate of return
Nominal rate of return is often used to compare the performance of different investments over different time periods. It can be used in various applications, such as:
- Evaluating an investment's performance over a given period in comparison to another investment or benchmark.
- Monitoring an investment's performance over time.
- Comparing the returns of different investments to decide which one to invest in.
- Determining an investment's expected return for a given period of time.
- Estimating the return of a portfolio of investments.
- Calculating taxes due on an investment.
Types of nominal rate of return
Nominal rate of return can be classified into four types:
- Money-weighted rate of return: This is the rate of return based on the cash flows of an investment and takes into account the timing and amount of all cash flows. It is used to measure the performance of an investor's portfolio over a specific period of time.
- Time-weighted rate of return: This is the rate of return based on the timing of the cash flows and takes into account the time value of money. It is used to compare the performance of an investment to a benchmark or index.
- Internal rate of return: This is the rate of return that makes the present value of all cash flows of an investment equal to zero. It is used to measure the profitability of an investment and is used to compare the profitability of different investments.
- Holding period return: This is the rate of return of an investment over a specific period of time. It is calculated by subtracting the purchase price from the sale price of the investment and dividing it by the purchase price. It is used to measure the performance of an investment over a specific period of time.
Advantages of nominal rate of return
Nominal rate of return offers several advantages when measuring the performance of an investment. These advantages include:
- Simplicity: Nominal rate of return is relatively easy to calculate, as it only requires the beginning and ending values of an investment to be compared, allowing for a straightforward calculation of the rate of return.
- Comparability: Nominal rate of return allows for the comparison of investments over different time periods, as the rate of return is expressed in the same currency.
- Realism: Nominal rate of return reflects the true rate of return on an investment, as it does not take into account the effects of inflation or purchasing power.
Limitations of nominal rate of return
The nominal rate of return has several limitations that should be considered when evaluating investment performance. These include:
- Not taking into account the effects of inflation: The nominal rate of return does not take into account the effects of inflation, which can significantly reduce the value of an investment over time. This can lead to an inaccurate measure of an investment's true performance.
- Not taking into account purchasing power: The nominal rate of return does not take into account the decreased purchasing power of money due to inflation. This means that the same amount of money today is not worth as much as it was in the past, which could lead to a false measure of the investment's performance.
- Not taking into account taxes: The nominal rate of return does not take into account the effects of taxes, which can reduce the return on an investment.
- Not taking into account fees and costs: The nominal rate of return does not take into account the fees and costs associated with an investment, which can also reduce the return on an investment.
Nominal rate of return is just one of the approaches used to measure the performance of investments. Other approaches include:
- Real rate of return: This approach takes into account the effects of inflation and purchasing power by expressing the rate of return in terms of constant-dollar changes.
- Total return: This approach measures the performance of an investment over a given time period by taking into account both changes in the nominal value of the investment and any income generated, such as dividends or interest payments.
- Time-weighted return: This approach measures the performance of an investment or portfolio by removing the effects of contributions and withdrawals made during the period.
- Internal rate of return: This approach takes into account the time value of money by measuring the rate of return that discounts all cash flows to the present.
In summary, nominal rate of return is only one of several approaches used to measure the performance of investments. Other approaches include real rate of return, total return, time-weighted return, and internal rate of return.
Suggested literature
- Boughton, J. M., & Fackler, J. S. (1981). The nominal rate of interest, the rate of return on money, and inflationary expectations. Journal of Macroeconomics, 3(4), 531-545.
