Real Rate of Return

This formula converts a quoted return into a "real" return by removing the effect of inflation. It works because your investment first grows by the nominal rate, and then the higher price level reduces what that money can buy; dividing by 1+i captures that second effect exactly. The result tells you the growth in purchasing power, not just the growth in dollars.

Use this when comparing investments, savings accounts, bonds, or wages in an environment where prices are changing. It is especially important for long-term financial planning, valuation, and any analysis where the true increase in buying power matters.

• Subtracting inflation directly from nominal return without checking whether an approximation is acceptable
• Using the inflation rate in percent form (4) instead of decimal form (0.04) inside the formula
• Forgetting that the result is a real rate, so a positive nominal return can still become a low or even negative real return