Unreal Yields

I want to address a concept here that is widely used in the financial media – no, let’s make that misused.  Out of every 100 times I see a “real yield” referred to, probably 99 times it’s so sloppy and careless that it’s somewhere between misleading and useless.  Better yet flat out wrong.  Not only by financial reporters  but even serious economists.  Yet the error is so simple the average sixth grader could instantly appreciate it once brought to his attention.  

So this won’t take very long.  It’s like subtracting apples from oranges to calculate bananas.  

In this case we want to subtract inflation from nominal yield to find real yield.  Sounds simple, right?  But wouldn’t you think it goes without saying that to get a valid answer you need to start with nominal yield and inflation taken over the same time frame?  

Quick, what’s the real yield of a bond that has a nominal yield from 1980 to 1990 of 6% if the rate of inflation during 1979 to 1980 was 12%?  

Having a hard time with this one?  Me too.  Yet this kind of absurdity passes without question on a daily basis in the financial media.  Routinely you will see claims like the “real” ten year yield is around 1% based on its ‘current’ nominal yield of 3% and inflation ‘running’ around 2%.  Folks, just stop and think about this for a second.  That ‘current’ yield is over the next ten years.  A future span of time.  The inflation figure is usually based on a change in price level over the trailing year.  A past span of time.  There’s not even any overlap.  The truth is the analyst casually tossing out this figure has no clue what the real yield on that ten year bond will be.  It’s a gross pretense.  Even the next one year minus the last one is logically invalid.  Just one example of why you should read financial statistics critically and with abject skepticism.

‘Nuff said.

2 thoughts on “Unreal Yields

  1. jk says:

    buying a 10 year bond is not a commitment to holding that bond for 10years. one could calculate the yield for holding that bond for just the next 1 year [if only you knew what rates would be a year out and how that would effect the value of the bond] and subtract an estimated forward-looking inflation rate for that period. then you could do it for a 6 month period, a 3 month period, and so on. we’re doing calculus and trying to estimate the instantaneous yield minus the instantaneous inflation rate. tough work, indeed.

    nonetheless, i think the “real” utility of the concept of “real return” is to remind people to pay attention to how inflation can lower the value of their investment. as you, more than anyone i can think of, well know, inflation and the varying value of the dollar doesn’t receive the respect and attention it deserves.

    1. Bill Terrell says:

      Don’t get it … are you saying that it’s logically valid to subtract inflation taken over one time frame from a nominal rate taken over a different one?

      If not, then much ado about nothing. No one has disputed the notion that qualitatively inflation subtracts from the real return on an investment. The problem is the way it’s commonly quantified. Calculated. Yes, we’re holding that up for ridicule, well-deserved at that.

      If so, then we’ll just let that speak for itself!