What It Measures
Why It Is Important
Rate of return is a simple and straightforward way to determine how much investors are being paid for the use of their money, so that they can then compare various investments and select the best—based, of course, on individual goals and acceptable levels of risk.
How It Works in Practice
There is a basic formula that will serve most needs, at least initially:
Rate of return = (Current value of amount invested – Original value of amount invested) ÷ Original value of amount invested
If $1,000 in capital is invested in stock, and one year later the investment yields $1,100, the rate of return of the investment is calculated like this:
(1100 – 1000) ÷ 1000 = 0.1 = 10%
Now, assume $1,000 is invested again. One year later, the investment grows to $2,000 in value, but after another year the value of the investment falls to $1,200. The rate of return after the first year is:
(2000 – 1000) ÷ 1000 = 1 = 100%
The rate of return after the second year is:
(1200 – 2000) ÷ 2000 = –0.4 = –40%
The average annual return for the two years (also known as average annual arithmetic return) can be calculated using this formula:
Average annual return = (Rate of return for year 1 + Rate of return for year 2) ÷ 2
(100% + –40%) ÷ 2 = 30%
Be careful, however! The average annual rate of return is a percentage, but one that is accurate over only a short period, so this method should be used accordingly.
The geometric or compound rate of return is a better yardstick for measuring investments over the long run, and takes into account the effects of compounding. As one might expect, this formula is more complex and technical, and beyond the scope of this article.
Tricks of the Trade
The real rate of return is the annual return realized on an investment, adjusted for changes in the price due to inflation. If 10% is earned on an investment but inflation is 2%, then the real rate of return is actually 8%.
Some mutual fund managers have been known to report the average annual rate of return on the investments they manage. In the second example, that figure is 30%, yet the value of the investment is only $200 higher than it was two years ago, or 20%. So, read such reports carefully.