Why people tend to think in Nominal terms?
In finance and economics, a nominal value means the unadjusted value of an asset. Nominal value does not take into account inflation. Whereas, real value is excludes the impact of inflation.
It is very important to differentiate between the two, and to understand why nominal and real values differ over time. To illustrate the basic concept, consider the following example:
You deposited Rs 100 in a savings bank account and the interest rate is 4% per annum. You will have Rs 104 in your account by the end of the year. In nominal terms, you have gained Rs 4. However, if you think about it in real terms, and factor in the inflation of 5% through the year, you will realize that you have lost 1% (4%-5%) in that year. All interest rates cited by banks and other financial institutes are nominal interest rates. At this point, it becomes important to differentiate between stated rates of return (nominal rates) and effective rates of return (real rates).
Time Value of Money
The concept of Time value of Money states that money in our hands now is worth more than money in our hands in the future. This is because we can earn more interest on that money, so, the sooner we receive it the better. Understanding the Time value of money is at the foundation of thinking about our investments in real terms.
A simple formula used to calculate present and future values of money is:
FV= PV (1+r) n
Where FV= Future Value
PV= Present Value
R= Rate of interest/required rate of return
n= Number of compounding periods (usually, the number of years)
For example, if a person wants to invest Rs 1000 for 4 years and his required rate of return is 8%, then
FV= 1000 (1+0.08)4 = 1000 * 1.084 =Rs 1360.49
Thus, the future value of his investment after 4 years at a rate of return of 8% is Rs 1360.49
(1+r)n is the compounding factor. To find the present value of future investments or payments, we just manipulate the formula by taking the compounding factor to the other side and dividing the future value by the compounding factor. (PV= FV/(1+r) n)
Taking real values of future financial returns into account helps us to make better and clearer decisions. Thinking in terms of constant rupees (as opposed to current rupees) and real interest rates broadens the perspective of the investor and facilitates managing long term future gains.
The real value tells us a more complete picture of the value of our investments. If you think about your investments in real terms, you are considering more factors (especially inflation).
The increase in prices of products over time, and the reduction in one’s purchasing power is one of the most crucial factors to account for in investing.
Inflation is directly linked with this concept because a person’s purchasing power shrinks over time as the real value of their money decreases.
The average annual inflation rate in India between 2010 and 2019 was 6.62%.
As we can see from the above graph, historically, the inflation rate in India has been very volatile. Therefore, it is beneficial for a long-term investor to take into account at least 10-15 year annual average rate of inflation when calculating the real rate of return on his investments.
It would be advisable for an investor to factor in about 7% inflation and subtract that from the stated nominal rate of return. This effective rate of return will reflect a more accurate interest rate on their investment.
Thinking about finances and money in nominal terms and mistaking its face value for its purchasing power is a human cognitive bias, known as the Price Illusion. Accounting for other factors and thinking in real terms can help investors increase their gains substantially.
In the long-term, only considering nominal rates can even lead to negative returns, a loss in purchasing power and bad decision-making with regards to investments. Hence, considering the real rates of return is of utmost importance, especially while making key decisions.