Transcript
Your bank shows you a number every month — a balance, a rate, a percentage gain — and that number is almost certainly incomplete. Not dishonestly. Not deliberately. But in a way that compounds quietly over years and decades until the gap between what you think you have and what you actually have becomes genuinely significant. Understanding that gap is the entire reason investing, as a practice, exists.
This episode covers one foundational concept: the difference between a nominal return and a real return. It sounds technical, but the idea is straightforward once you have the right framework. By the end, you will understand what inflation actually does to savings over time, why the figures on your bank statement are not the full story, what the long-run evidence says about cash compared with other assets, and what the strongest honest case for holding cash actually looks like — because there is one, and it deserves a fair hearing.
If you have money in a savings account, a term deposit, or a bank account of any kind, inflation is working on that money right now. It does not show up as a line item. It does not trigger an alert on your banking app. But it is real, and it operates whether you are aware of it or not. The question of whether your savings are actually growing — in terms of what they can buy — is a different question from whether the number in your account is growing. Most people conflate the two. That conflation has a name in behavioural economics: money illusion. We will get to that.
First, some history, because this distinction did not emerge from nowhere.
The separation between nominal and real values is one of the older insights in economics. Irving Fisher, the American economist writing in the early twentieth century, formalised the relationship between nominal interest rates, real interest rates, and inflation expectations. His core observation was simple: a lender charging ten percent interest in a year when prices rise ten percent has not gained anything in real terms. The purchasing power of the repayment is exactly what the principal was worth at the start. Fisher argued that rational lenders would factor expected inflation into the rates they charge — what we now call the Fisher effect. That insight became foundational to how central banks, bond markets, and investment theory all operate today. The Reserve Bank of Australia, like the US Federal Reserve and most modern central banks, targets inflation explicitly — the Fed's stated target is around two percent — precisely because stable, predictable inflation allows everyone in the economy to plan in real terms, not just nominal ones.
The distinction between nominal and real is not a technicality invented by financial advisers. It is a structural feature of how money and time interact.
Now for the mechanics, because you need these to follow everything that comes after.
A nominal return is the raw, unadjusted percentage gain on an investment. If you put a thousand dollars in a term deposit and it returns forty dollars after a year, your nominal return is four percent. That is the number your bank advertises. That is the number on your statement.
A real return strips out inflation to show what actually happened to your purchasing power. If inflation ran at three percent during that same year, your real return is not four percent. Using the simple approximation — nominal minus inflation — it is roughly one percent. But the more precise formula, as Wall Street Prep and SmartAsset both specify, is this: take one plus the nominal rate, divide it by one plus the inflation rate, then subtract one. So for four percent nominal and three percent inflation: 1.04 divided by 1.03, minus one. That gives you approximately 0.97 percent. Close to the approximation, but not identical.
Why does the precise formula matter? Because as inflation rises, the gap between the two methods widens. At two percent inflation, the approximation is close enough for most purposes. At seven or eight percent — which Australia saw in 2022 and 2023, and which earlier generations experienced during the 1970s and 1980s — the approximation meaningfully understates the erosion. The simple subtraction becomes less reliable exactly when accurate measurement matters most.
There is also a third layer, noted by the US Securities and Exchange Commission's investor education site: taxes. In most jurisdictions, including Australia, you pay tax on nominal gains, not real gains. If your term deposit earns four percent and inflation is three percent, you owe tax on the full four percent. Your after-tax, after-inflation return — the number that actually reflects what you kept in real terms — is lower still. This does not make any particular financial product better or worse than another; individual tax circumstances vary enormously. But it does mean the full erosion picture is wider than the nominal-minus-inflation calculation alone suggests.
With that framework in place, here is what the numbers actually show.
SmartAsset provides a useful illustration. Assume inflation is running at three percent. A cash savings account returning three-and-a-half percent nominally yields a real return of just 0.49 percent under the precise formula. Government bonds at five percent nominal yield 1.94 percent real. Equities returning ten percent nominally yield 6.80 percent real. The nominal differences look like a gradient. The real differences are a canyon.
Flip the scenario slightly. Dunbrook Associates gives this example: a bond returning three percent against four percent inflation produces a negative real return of approximately minus one percent. The investor's account balance went up. Their purchasing power went down. The number looked fine. The outcome was not.
This is where money illusion enters the picture.
Money illusion is the tendency to think about economic value in nominal terms rather than real ones — to treat a dollar as a dollar regardless of what a dollar can actually buy. It is not a character flaw. It is a predictable feature of how people process financial information, partly because nominal figures are what gets reported. Your savings account balance does not show an inflation-adjusted figure. Your bank's advertised rate does not come with a purchasing power disclaimer. Brokerage statements, marketing materials, and newspaper headlines almost universally report nominal returns. When everything you see is nominal, anchoring to nominal figures is the path of least resistance.
The practical consequence is that people systematically overestimate how much their wealth has grown. Someone who holds cash at two percent during a three-percent inflation period may feel like they are making progress — the number is going up — while in reality they are losing purchasing power at roughly one percent per year. Over a decade, that is not trivial. Over two or three decades, it becomes a material difference in what your savings can actually fund.
Before going any further with that argument, the strongest case for holding cash deserves a full and honest hearing — because it is a real case, and dismissing it cheaply would leave you with an incomplete picture.
Cash is not irrational. For short time horizons — money you will need within one to three years — cash is often the most appropriate place to hold savings. If you need to access funds for a specific purpose, a house deposit or an emergency, the risk of your balance falling is more consequential than the risk of modest inflation erosion. Cash does not fluctuate. You cannot lose your nominal principal in a savings account in the way you can in an equity market that falls thirty percent in a year.
There is also the concept of sequence-of-returns risk, which matters especially for people near or in retirement. If you are drawing down savings and your portfolio falls sharply early in that drawdown, the maths works against you in a way that is difficult to recover from. Holding a portion of assets in cash or near-cash during those years is a structural buffer, not a failure to understand inflation.
Capital preservation is a legitimate goal. Liquidity is a legitimate goal. And there are periods — high-inflation, rising-rate environments — when term deposits and short-duration instruments actually do provide meaningful real returns. Between 2023 and 2024, Australian term deposits were offering rates in the four-to-five percent range at a time when inflation, though elevated, was coming off its peak. The real return from cash was not compelling, but it was not deeply negative either.
The case for cash, fairly stated: it provides certainty of nominal value, liquidity on demand, and protection against short-term market volatility. For money with a short time horizon or a specific near-term purpose, those properties are worth something.
The problem is when those properties are applied to money with a long time horizon — retirement savings, generational wealth, financial goals that are ten, twenty, or thirty years away. At that point, the characteristics that make cash valuable for short-term purposes become liabilities. Certainty of nominal value becomes exposure to inflation erosion. The absence of volatility becomes the absence of real growth. What was a feature over one year becomes a cost over twenty.
This is where the long-run evidence matters most.
The research underlying this episode does not include a long-run Australian asset class return series with full real-return data — that gap is worth naming honestly. What the sources do establish clearly, and what is consistent with the broader financial literature, is the directional pattern. Equities, which represent ownership of businesses that can raise prices and grow earnings over time, carry a structural partial hedge against inflation that fixed-rate instruments do not. A bond with a fixed coupon pays the same amount in nominal dollars whether prices have risen fifteen percent or two percent. An equity holding reflects the underlying earnings power of the business, which tends — imperfectly, inconsistently, but over long periods — to move with the broader economy.
SmartAsset makes this point explicitly: at three percent inflation, the gap between a cash real return and an equity real return is not a few tenths of a percent. It is more than six percentage points, annually. Compounded over decades, that gap is not academic.
The compounding point matters, because inflation's effect builds in the same way investment returns do — exponentially. FundingSouq and Dunbrook Associates both note that the erosion is particularly significant when it accumulates over time, and harder to see over long horizons precisely because there is no single moment when you feel it. You do not wake up one day and find your balance reduced. Instead, you find that the same balance buys less — gradually, invisibly, cumulatively. A real return of half a percent per year over thirty years produces meaningfully less purchasing power than a real return of four percent per year over the same period. The maths is unambiguous on that.
There are two formulas for real return in the research, and it is worth acknowledging the tension between them. The simple subtraction — nominal minus inflation — is pedagogically clean and fine under low-inflation conditions. The precise formula — one plus nominal, divided by one plus inflation, minus one — is technically correct in all conditions and diverges from the approximation as inflation rises. Wall Street Prep and SmartAsset both flag this. FundingSouq uses the simple version without caveat. Neither is wrong as an approximation tool; the precise version is more accurate when stakes are high and inflation is not low. Knowing both, and knowing when they diverge, is part of using the concept correctly.
What remains genuinely open after all of this? A few things.
The behavioural research on money illusion — how widespread it actually is among Australian retail savers, whether it responds to financial education, how it interacts with trust in financial institutions — is not well captured in the sources reviewed here. The concept is well established theoretically, but the empirical scale of the bias among ordinary savers is a genuine open question.
The tax dimension is also underdeveloped. The fact that Australian savers pay tax on nominal interest income, not real income, means the after-tax real return from cash is structurally lower than the pre-tax calculation suggests. How much lower depends on individual tax rates and circumstances, which vary considerably.
And the long-run real return record for Australian asset classes specifically — not US data, not global aggregates, but Australian equities versus Australian cash over multi-decade periods in real terms — is a gap this episode does not fully close, because the research did not provide it. It is a reasonable next layer of investigation for grounding these principles in specifically domestic evidence.
Here is where this lands.
The nominal return on your savings account is not the measure of whether your savings are growing in any economically meaningful sense. The real return — adjusted for inflation, and further adjusted for tax — is the relevant number. The two can diverge substantially, and the direction of that divergence is almost always unfavourable for cash holders over long periods.
Money illusion — the tendency to anchor to nominal figures — makes this gap easy to miss and easy to underestimate. The figures that appear on statements and in bank advertising are almost always nominal. They are not wrong. They are incomplete.
Cash has genuine virtues: liquidity, nominal capital certainty, suitability for short time horizons and specific near-term purposes. Those virtues are real. They are also time-horizon-dependent. Applied to long-duration savings goals, they become a form of slow erosion rather than safety.
The reason investing in assets other than cash exists — as a practice, as an idea, as a structure — is precisely this gap. The gap between what cash pays and what inflation takes is not a market anomaly or a temporary condition. It is the baseline from which every other asset class is measured. Understanding that baseline in real rather than nominal terms is the difference between knowing what your money is doing and knowing only what your statement says.