Inflation can wreck an otherwise strong portfolio by reducing the buying power of your investment's return. Maybe your investment raked in a solid $1,000 for a 2 percent return. Not bad; at least you made money. Or did you? Although you may be sitting on 2 percent more money, if inflation made everything 3 percent more expensive, you're actually going backwards. To calculate your real return, you have to consider the effect of inflation.
Subtract the amount invested from the total amount you made from the investment. As an example, if you invested $10,000 and it grew to $10,404 in two years, subtract $10,000 from $10,404 to calculate a $404 profit.
Divide the profit by your original investment to calculate the return. Continuing with the example, $404 divided by $10,000 results in a 0.0404 nominal return across those two investment years.
Add 1 to the return and raise the result to the nth power, where "n" is the number of periods in a year. In the example, the investment period was two years, so one year encompasses just half of a period. Therefore, raise 1.0404 to the 0.5 power to calculate 1.02. This figure is the annualized nominal multiplier for your investment, but subtracting 1 calculates the annualized nominal return of 0.02, or 2 percent.
Add 1 to the inflation rate, which is found through the Bureau of Labor Statistic's Consumer Price Index publication. If the cost of all products rose 3.1 percent, as it did on average since 1925, then add 1 plus 0.031 to get an inflation multiplier of 1.031.
Divide the nominal multiplier by the inflation multiplier. In the example, 1.02 divided by 1.031 gets a real multiplier of 0.989.
Subtract 1 to calculate your annualized real return. Completing the example, 0.989 minus 1 calculates an annualized real return of -0.011, or -1.1 percent. The negative sign means your originally-positive investment actually lost money after factoring in inflation.
- Jupiterimages/liquidlibrary/Getty Images