Have you heard of inflation? When your wife complains that the prices of food grains and vegetables have gone up sharply, that is just an example of inflation. To simplify, nominal returns and real returns, the difference is all about inflation. But before getting into real returns let us understand nominal return. Let us start with debt. Assume that you bought a Rs.100 face value 10% debenture at Rs.99 in the market. Assume that the debenture is redeemable at the end of 1 year at face value. Your nominal return at the end of the year is Rs.11 (Re.1 profit + Rs.10 interest) or 11.11%.
Let us also understand nominal returns in the case of equities. If you bought the stock of XXX Ltd. at Rs.150 and sold it at the end of the year at Rs.175 and the company also paid a dividend of Rs.3 per share then your nominal returns will be Rs.28 (Rs. 25 profit + Rs.3 dividend) or 18.67%. Nominal returns are always annualized in % per annum.
When you deduct the rate of inflation from nominal returns, you get a real return. If your wife tells you that her budget expenses have gone up by 10% in the last 1 year, then that is a case of inflation. It is the rate at which prices are increasing in the economy on an annual basis. Inflation affects your returns because the value of money goes down. If inflation is 5% per annum, then Rs.100 today will be worth just Rs.95 at the end of 1 year. Hence real return tells you what you actually earn on your investment after adjusting for inflation.
Inflation becomes important as countries with higher inflation have higher interest rates (like India) and countries with lower inflation have lower interest rates (like the US).