The rate of return is a basic measurement used to calculate the performance of an investment and compare it to other investment options. It is the percentage change in the value of an investment over a period of time.
When should you use the rate of return? What are some examples of how to calculate your rate of return? And, how does it benefit the individual investor? These are some of the questions answered in this guide so you can become a better investor.
Definition and Examples of Rate of Return
The rate of return is the gain or loss of an investment over a period of time stated as a percentage. The Securities and Exchange Commission (SEC) defines the annual rate of return as “the percentage change in the value of an investment.” A rate of return can be stated in any timeframe such as daily, weekly, monthly, or annually, but it’s most often referred to as an annual rate.
The rate of return can be stated as a positive percentage or a negative percentage in the case of a loss.
To calculate the rate of return, you divide the total net profit by the beginning balance and multiply that by 100 to get the percentage growth (or loss) of your investment.
Let’s say you put $5,000 into an exchange-traded fund (ETF). A year later, that money is worth $5,500, making your total profit $500 with a positive annual rate of return of 10%. Conversely, if you put $5,000 into an ETF and a year later that money is worth $4,500 your total loss is $500 and a negative annual rate of return of 10%.
How Rate of Return Works
To calculate the rate of return, all we need to know is the starting balance and the ending balance of your investment. This will determine your net profit or loss, which you then divide by your initial investment, and multiply by 100 to express it as a percentage. The rate of return formula is as follows:
Let’s break down the equation with a more detailed example. Jane decides to invest $100,000 of stock, split up amongst her top 10 favorite companies. After a year of owning these 10 stocks, she finds that her stock portfolio is now worth $112,000. For Jane to calculate her rate of return, we need to determine her net profit or loss and divide that by her initial investment. Here’s how we would calculate Jane’s rate of return:
- Calculate her net profit or loss: $112,000 - $100,000 = $12,000 net profit
- Divide the net profit or loss by the initial investment: $12,000 / $100,000 = 0.12
- Multiply 0.12 by 100 to get a percentage: 0.12 x 100 = 12%
Jane invested $100,000 into the stock market which grew to $112,000 equaling a profit of $12,000. A growth of $12,000 from a $100,000 initial investment equals a 12% rate of return.
Alternatives to Rate of Return
There are alternative rates you can use that are all based on the basic formula of the rate of return. Some of them include the Internal Rate of Return (IRR) and Compound Annual Growth Rate (CAGR).
Internal Rate of Return
Internal Rate of Return (IRR) is the discounted rate of all future cash flows of an investment. If you expect an investment to return 10% per year for the next five years, we would take those returns of each of the five years respectively and discount those to the net present values. The rate required to discount those cash flows is the IRR.
The formula to calculate IRR is very complex and most often requires a calculator.
Compound Annual Growth Rate
Compound Annual Growth Rate (CAGR) is the annual growth rate of an investment taking into account the effect of compound interest. The formula for computing CAGR is as follows:
CAGR = (Ending Balance / Beginning Balance)(1 / No. of Periods) - 1
If you invested $1,000 and after five years it is worth $1,500, you’d have a rate of return of 50%. However, your compound annual growth rate would be 8.45% per year compounded over five years.
Return on Equity
When investing in stocks, Return on Equity (ROE) can be helpful in seeing if a company is using your invested money in an efficient way. ROE calculates how much profit a company generates in respect to shareholders' equity. To calculate ROE, you take the total net profit and divide it by the total shareholders’ equity. Here’s what the formula looks like:
ROE = Net Profit / Shareholders Equity
Return on Assets
Return on Assets (ROA) calculates the total profit of a company in relation to its total assets. Assets include anything such as cash, equipment, inventory, real estate, machinery, etc. The formula to calculate ROA is as follows:
ROA = Net Profit / Total Assets
What It Means for Individual Investors
Rate of return is a powerful tool for investors to quickly calculate how well an investment is performing. It’s useful for comparing and forecasting potential investment products. Whether you’re investing for retirement, higher education, a down payment on a home, day trading, or building wealth, using the rate of return will give you a better visual on an investment's growth. That way, you can make decisions accordingly.
- The rate of return is the gain or loss of an investment over a period of time stated as a percentage.
- You can calculate the rate of return by taking the net profit, dividing it by the initial investment, and multiplying that number by 100 to make it a percentage.
- Alternative measurements to rate of return are internal rate of return, compound annual growth rate, return on equity, and return on assets.
- The rate of return allows investors to calculate the performance of an investment, compare investments, and even forecast potential investments.