Definition
The Nominal Rate of Return refers to the rate of return on an investment before taking inflation into account. It represents the amount of profit or loss achieved during a specified period, without considering the purchasing power of the money over time. Therefore, it doesn’t represent the ‘real’ rate of return, which adjusts for changes in price levels.
Phonetic
The phonetic pronunciation of “Nominal Rate of Return” is: ‘Naʊmɪnəl Reɪt ɒv Rɪ’tɜ:rn
Key Takeaways
When thinking about Nominal Rate of Return, here are the three main takeaways.
- Nature: The nominal rate of return is the amount of money generated by an investment before accounting for factors like taxes and inflation. It represents the rate of return without adjusting for potential impacts from external factors.
- Application: It is often used to compare the returns of different investments in a given period. However, it fails to provide the real earning of the investment as it doesn’t consider inflation or tax impact, hence leading to a distorted view of the profit or loss from an investment.
- Limited in terms of ‘real earnings’: Since the Nominal Rate of Return doesn’t consider the inflation or tax impact, the real earning or loss could be different from that which the nominal rate exhibits. A better metric to consider for understanding ‘real earnings’ is the ‘Real Rate of Return’ which adjusts the returns considering inflation.
Importance
The Nominal Rate of Return is a crucial business/finance term because it represents the percentage change in the value of an investment before considering the erosion effects of inflation. It provides investors with a base indicator of the potential return on an investment. However, it doesn’t provide an accurate picture when it comes to making comparisons or predicting future investment value. Nominal rates are also handy for lenders, as they portray interest rates without considering compounding’s effects. Understanding the nominal rate allows investors and decision-makers to perform initial calculations and assessments, even though they will typically need more detailed and realistic indicators to make optimal financial decisions.
Explanation
The Nominal Rate of Return is considered as a crucial financial performance metric in the field of investment and business. The primary purpose of the Nominal Rate of Return is to provide an investor or business person with a raw percentage value of the returns obtained on an investment or business venture without factoring in the effects of inflation. It is essentially used to quickly measure and understand the return from an asset or investment during a specific period.As a tool, the Nominal Rate of Return enables the investor to compare the growth of their investment with the initial capital or investment. It helps in setting their expectations on the return on investment, facilitating business decisions concerning whether to continue, discontinue, or enhance investment based on the analyzed performance. However, it’s crucial to remember that it does not reflect the actual buying power of the investor as it does not take into account the impact of inflation. Therefore, in an inflationary environment, a more comprehensive measure would be the real rate of return instead.
Examples
1. Savings Account: In a bank’s savings account, the bank offers a nominal rate of return of, say, 3% per annum. This means that for every amount deposited in the savings account, the bank will pay you 3% as interest annually. 2. Company Share Investment: If an investor buys shares in a corporation and the share price rises by 5% within the year, excluding any dividends, then 5% is the nominal rate of return on the share investment.3. Treasury Bonds: A US treasury bond might have a nominal return rate of 2%. This means that for every $100 invested in these bonds, the investor will receive $2 per year. However, this does not account for inflation, which means the true earnings (real rate of return) may be lower.
Frequently Asked Questions(FAQ)
What is a Nominal Rate of Return?
The Nominal Rate of Return is the amount of money generated by an investment before factoring in expenses such as taxes and inflation. It provides investors with a raw percentage of growth or loss.
How is the Nominal Rate of Return calculated?
The Nominal Rate of Return is typically calculated by comparing the amount of money generated at the end of the investment period to the amount of money invested initially. This gives the raw total growth, which is then expressed as a percentage.
What is the difference between Nominal Rate of Return and Real Rate of Return?
The main difference between the two is that the Real Rate of Return takes into account inflation, while the Nominal Rate of Return does not. This means that the Real Rate of Return often gives a more accurate portrayal of the investment’s profitability.
Can the Nominal Rate of Return be negative?
Yes, the Nominal Rate of Return can be negative if the investment loses money. This often happens when the investment’s worth decreases.
Why is the Nominal Rate of Return important to investors?
Understanding the Nominal Rate of Return can help an investor decide whether or not to invest in a certain asset. It gives them an idea of the potential growth or loss of the investment.
How often is the Nominal Rate of Return used?
The Nominal Rate of Return is generally used in short-term investments where inflation doesn’t have a significant impact. It also serves as a starting point for more complex calculations like the Real Rate of Return.
Does the Nominal Rate of Return consider the risk involved in investments?
No, the Nominal Rate of Return does not consider the risk involved in investments. It simply represents the potential earnings or losses an investment could deliver.
Can I rely solely on Nominal Rate of Return for financial decisions?
Although Nominal Rate of Return can illustrate potential profitability, it’s essential to consider other factors, like taxes, inflation, and risk, before making any financial decisions. Therefore, relying solely on the Nominal Rate of Return would not give a complete picture of the investment’s value.
Related Finance Terms
- Real Rate of Return
- Inflation
- Interest Rate
- Investment Return
- Capital Gains
Sources for More Information
