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Home > QFINANCE Dictionary > Definition of rate of return

Definition of

# rate of return

Accounting

ratio of investment profit to investment cost an accounting ratio of the income from an investment to the amount of the investment, used to measure financial performance.

There is a basic formula that will serve most needs, at least initially:

[(Current value of amount invested − Original value of amount invested) / Original value of amount invested] × 100% = Rate of return

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:

[(1,100 − 1,000) / 1,000] × 100% = 100 / 1,000 × 100% = 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:

[(2,000 − 1,000) / 1,000] × 100% = 100%

The rate of return after the second year is:

[(1,200 − 2,000) / 2,000] × 100% = −40%

The average annual return for the two years (also known as average annual arithmetic return) can be calculated using this formula:

(Rate of return for year 1 + Rate of return for year 2) / 2 = Average annual return

Accordingly:

(100% + −40%) / 2 = 30%

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 term, and takes into account the effects of compounding. This formula is more complex and technical.

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%.

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Definitions of ’rate of return’ and meaning of ’rate of return’ are from the book publication, QFINANCE – The Ultimate Resource, © 2009 Bloomsbury Information Ltd. Find definitions for ’rate of return’ and other financial terms with our online QFINANCE Financial Dictionary.