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Inflation and real and nominal return. Created by Sal Khan.

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Finance and capital markets on Khan Academy: If the value of money is constantly changing, can we compare investment return in the future or past to that earned in the present? This tutorial focuses on how to do this (another good tutorial to watch is the one on “present value”).

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Real and Nominal Return: Understanding Inflation’s Impact on Investments

In the world of finance and capital markets, understanding the concepts of real and nominal return is crucial for making informed investment decisions. One factor that significantly affects these returns is inflation, a term that often arises when discussing economic growth and monetary policies. Khan Academy offers a comprehensive resource to help investors navigate this complex relationship and comprehend the intricacies of managing their wealth.

To begin, let’s define real and nominal return. Nominal return refers to the absolute change in the value of an investment over a given period, usually expressed as a percentage. It does not take into account the effects of inflation and thus gives an inaccurate representation of the purchasing power of one’s investments in the long term. On the other hand, real return accounts for inflation, allowing investors to evaluate their investments’ true earning power.

Inflation, simply put, is the rate at which the general level of prices for goods and services is rising and, therefore, eroding the purchasing power of currency. While a certain level of inflation is considered healthy for stimulating economic growth, higher levels can harm both individuals and businesses. For investors, inflation erodes the value of their investments over time and can potentially diminish their financial well-being.

Khan Academy’s lesson on inflation clearly explains how it affects investments, emphasizing the importance of considering inflation-adjusted returns. The resource demonstrates how to calculate real return by subtracting the inflation rate from the nominal return. This simple equation provides a more accurate reflection of an investment’s growth while accounting for the impact of rising prices.

Understanding the effects of inflation on different investment types is integral to creating a diversified portfolio that can preserve and grow wealth. Some investments, such as stocks, may have historically outperformed inflation, providing a positive real return. Conversely, fixed-income investments like bonds might struggle to match or surpass inflation’s pace, leading to negative real returns. Knowing this, investors can make more informed decisions about their asset allocations and adjust their portfolios accordingly.

Moreover, Khan Academy’s resource delves into the concept of the “real interest rate,” which reflects the adjusted return on an investment after considering inflation. The real interest rate aids in understanding the true cost and benefit of borrowing or lending money. It helps individuals and businesses evaluate the potential returns from investments against the inflation rate, enabling better decision-making regarding loans, mortgages, and other financial transactions.

In conclusion, understanding real and nominal return and the impact of inflation is vital for investors seeking to secure their financial future. Khan Academy’s comprehensive resource on finance and capital markets provides a well-rounded understanding of these interrelated concepts. Armed with this knowledge, investors can make informed decisions about their investment strategies, accurately measure their returns, and ultimately work toward preserving and growing their wealth in an inflationary world.