3. Nominal versus real: inflation as an invisible tax
Macro 1: The price of money
There is one mistake that ruins more portfolios than any bad stock pick, and it requires getting nothing wrong at all: counting your money without netting off how much the price of things has risen. It is called money illusion, and surviving it is the difference between believing you are making money and actually making it.
The sum almost nobody does properly
The nominal return is the one on your statement. The real return is the nominal minus inflation: it measures how your ability to buy things has changed.
The quick way to estimate it is to subtract, and for most cases that will do: 7% nominal minus 5% inflation is roughly 2% real. The exact way divides instead of subtracting, and the difference shows when the numbers are large: with 40% nominal and 30% inflation, subtraction suggests 10% real, when it is in fact 7.7%. With low inflation subtraction works; in a country with high inflation, subtraction always flatters you.
It is worth looking at from the other side, because that is the side that hurts. The rule of 72 says that to know how many years something takes to double, you divide 72 by the percentage. Applied to inflation: at 3% a year, prices double in 24 years. At 7%, in just 10. A saver who put money under the mattress in 2010 and took it out in 2024 did not lose a single euro of their own, and yet lost roughly a third of what that money could buy.
The tax nobody calls a tax
Here comes the part that is almost never explained and that changes the arithmetic completely: the taxman charges you on your nominal return, not your real one.
An example with round numbers. You invest 10,000 euros, make 6% nominal over the year and inflation has been 4%:
- Nominal gain: 600 euros. Your real return before tax is barely 2%, some 200 euros of purchasing power.
- Capital gains tax, at a rate of 19%: it is charged on the 600, not on the 200. That comes to 114 euros.
- You are left with 486 nominal euros, that is, 4.86% nominal. Taking off the 4% inflation, your real return after tax is around 0.86%.
In practice you have handed over more than half of your real gain. And had inflation been 6%, your real gain would have been zero and you would still have paid 114 euros: tax on a profit that never existed. This mechanism is why inflation is sometimes described as the tax that needs no parliament to approve it.
How inflation is measured, and why the official figure is disputed
The figure published by the statistics offices (the IPC in Spain, the CPI in the United States) is the price of a basket of goods and services weighted by what an average household consumes. The key word is *average*: if you spend half your salary on rent and rent goes up 10%, your personal inflation looks nothing like the published one.
There are three technical points worth knowing because they generate constant argument:
- Substitution. If beef soars and people switch to chicken, the index adjusts the basket. Critics say this disguises a fall in living standards; defenders say it measures what people actually buy.
- Hedonic adjustment. If a computer costs the same as three years ago but is twice as powerful, the index records a fall in price. It is defensible and at the same time hard to swallow when you are paying the same.
- Housing. In the United States, the cost of owner-occupied housing is estimated using owners' equivalent rent, and it feeds into the index with a long lag. It is one of the reasons the official figure can trail what people actually feel.
Alongside the headline figure, core inflation is published, which strips out fresh food and energy. It is not that those prices do not matter; it is that they are so volatile that they hide the underlying trend, and central banks take their decisions looking at the trend.
What the market thinks is going to happen
For an investor, past inflation is history; what moves prices is expected inflation. And that expectation can be read straight off the market: the gap between the yield on an ordinary bond and that of an inflation-linked bond of the same maturity is, roughly, the inflation the market is pricing in for that period. It is known as the breakeven rate, or simply the *breakeven*.
This has a first-order practical consequence. If CPI comes in at 6% and the market expected 6.5%, bonds can rally hard that very day even though inflation is still sky-high. The market does not react to the figure, it reacts to the gap between the figure and what was already in the price. We will come back to this idea, because it is one of the most expensive to learn the hard way.
And a final warning that leads into the next module: the worst possible combination for a portfolio is high, sustained inflation. Between 1966 and 1982 the American stock market barely moved in nominal terms for sixteen years, and in real terms investors lost around two thirds of their purchasing power. Nobody remembers that period as a crash, because there was not one. The money simply drained away without any chart showing it.