Did you know the S&P 500 has had an annual average return of around 10.26% since its inception in 1957 through the end of 2023?

So why do so many people use a 7 - 8% return when they are retirement planning or playing around with a compound interest calculator?

Well, there are two reasons:

1. A more conservative approach. Just because the S&P 500 has returned 10% historically does not mean it will continue to return 10%. Future returns could be higher, but they could also be lower.

2. They are using real returns rather than nominal returns.

Wait, what does that mean?

Nominal returns refer to the percentage gain or loss on an investment without adjusting for inflation. This is the return you see on paper, representing the difference between what you initially invested and what it's worth now.

Real returns, on the other hand, adjust for inflation and reflect the actual purchasing power of your returns. Inflation erodes the value of money over time, so even if your investment grows nominally, the real value might be less due to inflation.

Example:

Nominal Return: You invest $100, and after a year, it grows to $110. Your nominal return is 10%.

Real Return: If inflation was 3% during that year, your real return is adjusted to reflect that. The formula is:

Using this formula:

In this case, while your investment grew by 10%, your actual purchasing power only increased by about 6.8% after accounting for inflation.

Conclusion

Nominal returns show your actual paper gains. Real returns show your investment’s true growth after taking into account inflation.

Until next week,

Darrell