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The risk library  /  Reserves and return

Art. 23 · Reserves and return · 3 min read

Real investment returns

Every number that has not been adjusted for inflation flatters you, and the flattery compounds.

The distinction is simple and consistently ignored. The nominal return is what the statement says. The real return is what you can actually buy with it afterwards.

Real return Roughly, the nominal return minus inflation. Precisely, (1 + nominal) ÷ (1 + inflation) − 1. At small numbers the subtraction is close enough; over long periods the difference compounds and stops being close enough.

A fund returning 5% while inflation runs at 3% is not returning 5%. It is returning a shade under 2%. Over one year the distinction feels academic. Over ten it is the difference between a reserve that grew and a reserve that didn't.

£100k £120k £140k £160k £162,900 on the statement £121,200 in today's money start 5 years 10 years £100,000 at 5% a year, with inflation at 3%. The gap is not a fee, a loss or a mistake. It is the part of the growth that was never really growth.
  • Nominal: what the statement shows
  • Real: what it will actually buy
Fig. 25 · Both lines describe the same money. Only one of them describes what you can do with it. Illustrative rates.

For money held against risk, this is sharper than it is for ordinary investment, because your liabilities inflate too. The reserve exists to buy rebuilding, plant, contractors and wages, and all of those get more expensive. In construction they have recently got more expensive faster than general inflation. A reserve growing at 4% against rebuild costs growing at 6% is going backwards while looking like it is going forwards.

There is a presentational corollary worth adopting as a rule. Long projections in nominal terms flatter whoever is showing them. A five-year chart climbing into large numbers is mostly inflation wearing a suit. State projections in today's money, or state both.

Use it

  • Restate every projection in today's money. If someone shows you a five-year growth chart, ask for the real-terms version. It is one line of arithmetic and it changes the picture.
  • Compare against the right inflation. For a reserve that funds rebuilding, general CPI is the wrong yardstick: construction cost indices are closer.
  • Judge accounts by their real return. An account paying 2% while inflation runs at 3% is losing you money slowly. That may still be the right home for the cash, but know that it is what you chose.

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Explanatory content only. This article describes how insurance and risk decisions work in general terms; it is not insurance, legal, actuarial, or investment advice, and it is not a recommendation to buy, keep or cancel any cover. Every figure and diagram is illustrative, chosen to make a mechanism visible, not to describe any particular business.