Real rates of return: Discussion
Computed real rates of return do have some drawbacks. One is that the measures of inflation we normally use (for example the CPI or CPI-U in the US) try to give a single summary of much different inflation rates for different goods. Such a summary may be a good measure or a bad measure of the cost-of-living for an individual. For example, buying a house may hedge fairly precisely the housing costs of an individual, and therefore it is essentially riskless for the individual, but looks risky when viewed under the lens of the CPI.Another difficulty with using real returns is that the CPI is not measured very frequently. We have daily and even intraday observations of stock prices, but the price level and inflation are only measured monthly. Even monthly inflation numbers are imprecise and are based not on prices at a point of time at the end of the month and rather on surveys of prices over time within a month.
Phil Dybvig
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It might seem obvious that using real returns is superior for decision-making to using nominal returns. After all, spending power at maturity is what investment is about. In some cases, however, we are trying to cover a liability that is not inflation-linked, as in most defined-benefit pension plans. Or, when comparing to a benchmark, so long as we are consistent, it does not matter whether we are using real or nominal returns. |
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Another concern relates to the availability of appropriate measures of inflation. For one thing, inflation numbers are not available over short time periods. Also, there is ongoing controversy about whether published inflation numbers are measuring what they should. |