Ok, so despite my obvious brilliance regarding all things CFA, I have seriously struggled with this since level I. I feel like the books flip flop on which is real and which is nominal, which one incorporates inflation and which one doesn’t. It would make sense to me that the one that incorporates inflation would be the real return, because that’s what you’re “REALLY” making, and the nominal is just a number, but does not include inflation. Sometimes I see evidence in the reading to support that, i.e. “the real return is inflation adjusted”. Other times it simply says that you add inflation to the real return to get the nominal return, which makes ZERO sense to me. If it doesn’t include inflation, WTF is so real about it? Can anyone clear this up for me, once and for all?
Real return is inflation adjusted. So… if I make 3,9% in a given year and inflation was 3,3%, the real return is 0,6%. So if I add inflation to the real return as you say, I add 3,3% inflation to my 0,6% real return and I have a nominal return of 3,9%. I have earned 3,9% (nominal) but my big mac has gotten 3,3% more expensive so in reality I can only buy 0,6% more big macs this year which is the real return. Hope this helps…
That does help, thank you. And now you need help from a nutritionist regarding your eating habits.
Real rate is the rate you make with zero inflation. In a real world inflation exists, so what you make has to be more than real rate to account for inflation. Nominal rate is what you make in aggregate. Nominal Rate(what you get paid) = Real rate(for productive use depending on supply and demand) + Inflation (depreciation of your currency)
I think what may be confusing Smarshy is that bonds set at nominal rates have an inflation expectation built into them (ex ante). So your T-Bill essentially has a real rate plus an EXPECTED inflation built in to get to the nominal rate. Once time passes and you ACTUALLY see what inflation was (ex post) you can determine your actual real rate of return. I also had a couple of confusing spots in the CFAI texts on calcualating return requirements. They do some assbackwards method of calculating the real rate in their answers. I come up with the same numbers doing it my way, but it confused me anyway. I think they do it to make me feel inferior. It works.
Let me also add some real world info to help you understand. If you have a dollar today, that buys you something worth $1.00. Lets say a cheeseburger at McDonalds. If inflation is 3% this year, then one can expect the cheeseburger at McDonalds to cost, one year later, $1.03. But you still have only $1.00 in your hand. Thus, you must spend .03 extra to buy the same thing. Inflation, therefore, has eaten away at the real value of your dollar. So lets amplify this and look at an investment. You buy one share of Citibank at $1.00. Inflation this year is still 3%. One year from now, that one share of Citibank is now trading at $1.03. You THINK you made 3% on that investment but in reality, inflation for the year was 3% meaning that same McDonalds cheeseburger went up in price 3%. Therefore, the 3% you THINK you made on that one share of Citibank doesnt really amount to much since your gain on the stock was EXACTLY the same as the increase in a random good. Therefore, you are no better off than you were. Your real return was zero. You made exactly the same as inflation. You made nothing really.
I guess my issue really is just with the wording. It just seems to me that “real” should be the one that INCLUDES inflation, since it reflects the real amount. It seems to me that inflation should be added to a nominal return to get the real amount. Does any one else see what I’m saying?
What’s confusing in the CFAI world is that they ‘add’ inflation to the real return. In the real world, the real return is not a number you see on a screen anywhere. You DERIVE the real return by adjusting the nominal return with inflation. It doesn’t make sense to add inflation to the real return because the nominal return is what you needed in the first place to get to the real return. So asking questions in the opposite direction just… well… sucks. Because it’s useless. Back to my big mac.
Smarshy: You need a break. Get some rest. No offense intended. 
Cheers
Smarshy, the real return is what you are actually earning, not what it seems like you are earning (nominal return). If you have a nominal return of 5% and inflation 5% then you are really not getting any richer. So your real return 0%. I think your confusion that what you seem to be getting i.e. 5% should be you ‘real’ return is understandable but I guess the point here is that things are not always what they seem and while it seems like you are getting 5% return you really aren’t. Hope this doesn’t confuse you more. I do understand though I had a problems understanding real vs imaginary images in first year physics.