I took a single economics class during my undergraduate, and I LOVED it! There are a number of incredibly useful concepts that can guide your thinking in all sorts of situations. Opportunity cost is a great way to consider alternatives and has helped me make better, more rational decisions.
The difference between real and nominal values is another of these concepts. When you first come across the terms, it’s natural to let your eyes glaze over and skip what could be a boring topic. Spending 5 or 10 minutes wrapping your head around their meaning is one of the foundational concepts for managing your money and understanding investments.
The difference between the real and nominal value is inflation. Most of us have a general idea of what inflation is: prices go up. It can either be viewed as (most) things getting more expensive or as the value of a dollar decreasing – both are accurate and are actually the exact same thing. When you hear about the inflation rate, this is typically measured by using a basket of representative goods (a gallon of milk, a gallon of gasoline, and a loaf of bread for example) and tracking how the cost of those items change over time.
At times in the past, inflation wasn’t an issue. When the American dollar was on a gold standard, it meant that each dollar could be exchanged for a set amount of gold ($20.67 from 1900 to 1933 for example). Gold has been viewed as a good store of value because its value stays constant. In Roman times, an ounce of gold would buy a nice set of clothes, during the Renaissance an ounce of gold would buy a nice set of clothes, and today an ounce of gold ($1,808.00 USD) buys a nice set of clothes.
ASIDE: I am NOT a “gold bug“. I don’t advise anyone to invest in gold and I don’t myself. I don’t advocate for a return to the gold standard or anything like that.
Deflation is also possible, which is where the price of things drops. We are all most familiar with this when purchasing computers – every year a brand new computer with comparable specifications gets cheaper.
The nominal value of something is simply the price we pay for it at that time. Consider the following prices for a loaf of bread:
1930 9 cents , 1940 10 cents , 1950 12 cents , 1960 22 cents , 1970 25 cents , 1980 50 cents , 1990 70 cents , 2008 $2.79 , 2013 $1.98
This is how we talk and think about prices in our daily lives.
The real value of something is the price we pay for it, in the currency of a reference year. If we consider the 1930’s bread above that cost 9 cents, we understand that 9 cents was worth much more back in 1930. It might be reasonable to ask, when was bread “more expensive” (for people of that time buying it), in 1930 or 2013? To evaluate this, we can use the real value. Since we’re most familiar with the currency of today, let’s put both prices in 2015 dollars.
Many sites provide the historical inflation rate. Often these will also have a simple inflation calculator. What the calculator is doing is taking the price of something and applying the inflation rate between the two periods to figure out what the value of that currency would be in a different year.
For example, between 1930 and 2015 there was 1,329.1% inflation. This means 9 cents in 1930 would be worth $1.29 ($0.09 * 1329.1%) in 2015. The inflation between 2013 and 2015 was 2.4%. This means $1.98 in 2013 would be worth $2.03 in 2015.
From this, we can say that it was cheaper for someone to buy a loaf of bread in 1930 than it is today – both in absolute terms (9 cents is less than $2) and in relative terms. In terms of what a dollar would have bought back then, bread was about 64% of the modern price.
Working In Real Values For Investments
When we think about investment returns, it’s very helpful to think in real terms instead of nominal terms. When considering my investments and lifestyle, will I be able to pay my expenses 40 years from now? What will food cost? What will housing cost? Will teleporter fees or paying for my pet alien from Ceti Alpha 3 eat into my savings? No one knows the answer to any of these things.
HOWEVER, if we assume things will cost about what they cost now, we can simply use today’s dollars for our expenses. Assuming that I’m spending roughly the same amount I am now, figure out what my investments will be worth in TODAY’s dollars. If there’s enough to pay the expenses, then I’m set.
Say I’m spending $2,000 per month and I want to put all my savings into treasury bills (T-bills) and live off the interest. The interest on a 30-year t-bill is 2.8922% today. This means that if I save $829,818.12 in T-bills, I would get $24,000 in interest ($2000 / month) from them in a year ($829,818.12 * 2.8922% / 12 = $2000). The problem is, as we just discussed, my living expenses will rise. If the annual inflation over the next year is 2%, then my cost of living will go up to $2040. But my T-bills just pay me $2000, so I’m short $40. This will get worse every year.
Instead, think about this in real terms. My 2016 expenses will be $2040 in 2016 dollars, but this is the same as $2000 in 2015 dollars. If I can adjust the interest rate on the T-bills to keep the money in 2015 dollars, then I can figure out how much I need. This is easy to do:
Real return = Nominal return – Inflation rate
If we use an average inflation rate of 3.22%, this means our real return from T-bills is 2.8922 – 3.22 = -0.3078%. Oh oh! What do we do with a negative rate? This basically tells us that with the current interest rates and historical inflation, we’ll be losing money buying T-bills! This is why no one wants to put money into T-bills or CDs these days! One alternative is “TIPS treasury inflation protected security (http://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm) which adjusts with inflation.”
Let’s look at another investment. The long-term return on the US stock market is around 9%. This is in nominal terms. Putting this into real terms, we have a real return of 9 – 3.22 = 5.78%.
Using this we can calculate that to provide $2000 / month we would need $415,224.91 (2000 * 12 / 0.0578) invested in the stock market. Each month we could spend $2000 + inflation, and this lump sum would continue to grow to produce enough to cover our inflation-adjusted expenses. In nominal terms, our monthly expenses would keep going up, but the value of our stock portfolio would as well. As prices went up, we would have exactly enough extra money to pay for the increase.
This *ISN’T* retirement advice. In this discussion, I’ve assumed that inflation is always exactly the long-term average (here I used 3.22% and that the stock market always gains exactly 9% a year. In reality, these averages come with massive volatility – inflation has been as high as 19.66% in 1917 and the stock returns in 2008 were worse than -30% (your stocks would have decreased in value by 1/3rd).
The 4% rule builds on these ideas, by providing a margin of error. Instead of hoping for the theoretical average of 5.78%, they use a 4% real return in the model and hope the other 1.78% will protect the investor from the bulk of the bad luck scenarios that are possible.