What is Rate of Return

Rate of return (ROR) is the financial gain or loss an investor receives on their investment. In other words, it’s the increase or decrease in the value of their investment, usually shown as a percentage. For example, an investor puts $100 into a savings account and after a year, they have $110. The additional $10 represents a RoR of 10 percent.

There are also negative returns whereby a loss is made on the initial investment. For instance, if the share price of a stock goes down by 10 percent, it would represent a negative RoR.

Investors will use RoR to evaluate future opportunities and compare past performance of financial instruments such as stocks, bonds, real estate, and even dividend payments. This is usually shown on an annual basis.

How to Calculate Rate of Return

The Rate of Return (RoR) measures the gain or loss on an investment over a set period, expressed as a percentage. It considers the initial investment, final value, and any capital gains or losses, interest, or any dividend income. We can calculate it using the following steps:

1. Find out the initial investment – the sum of money that was originally invested in the asset.
2. Work out the final value of the investment. This is the total value after increases in value from interest, capital gains, or dividends.
3. Find out the time period – the time that the investment was held for.
4. Calculate the total return of the investment. This is the final value minus the initial investment amount.
5. Calculate the RoR. Divide the total return by the initial investment amount, and then multiply by 100 to get the percentage RoR.

For example, you may invest $10,000 in a stock. This is the initial investment. If after one year, you sell it for $12,000, the total return would be $2,000. So to calculate the RoR, you need to divide the total return ($2,000), by the initial investment ($10,000). This then gives you 0.2. In order to get the percentage figure, you will need to multiply by 100, which gives you a final rate of 20%.

Rate of Return Formula

In order to calculate the rate of return, we can use the formula below:

To put it another way:

RoR = [(Ending value of investment – Beginning value of investment) / Beginning value of investment] x 100

To summarize, the formula shows:

1. The ending value of investment, which is the total value. This is the initial value plus or minus any dividends, capital gains or losses, and any interest.
2. The starting value, which is the initial sum invested.
3. We can see that by taking the total amount and subtracting the starting amount, we can see the difference between the two.
4. When we then divide that by the initial amount, we then get the percentage increase on the investments value.
5. By multiplying by 100, we can turn the decimal into a percentage.

For example, Mr Jones may invest $5,000 in stocks and sell them for $6,000 a year later. However, he also received $500 in dividends during the year. To calculate the RoR, this would look like:

[(6,000 + 500 – 5,000) / 5,000] x 100% = 30%

In turn, this means that Mr Jones had an annual rate of return of 30%.

Rate of Return (RoR) Calculator

Rate of Return Example

To best understand rate of return (RoR), it’s useful to take an example. Firstly, let’s say you invested $1,000 into a stock. One year later, that investment has grown to $1,500, and you have received $100 in dividends. To calculate the RoR, you can use the formula below:

RoR = [(Final value – Beginning value + Dividends) / Beginning value] x 100

So in this case, RoR = [(1,500 – 1,000 + 100) / 1,000] x 100

So the RoR = 60%

In turn, the RoR for that initial investment was 60 percent over the year. This factors in the appreciation in value from $1,000 to $1,500 – as well as the income generated through dividends.

Types of Rate of Return

There are three main types of rate of return (RoR), including total RoR, simple RoR, and compound RoR.

Compound Rate of Return

Compound Rate of Return (CRR) is a way of measuring investment growth that considers the effect of reinvesting earnings. This reinvestment can lead to higher levels of growth over time.

The CRR calculates how fast an investment grows over a period of time. It considers the initial investment as well as any additional earnings that the investment generates. The CRR formula takes into consideration the earnings which are reinvested each year. It then calculates the total return over a set period of time under the assumption that those earnings keep getting reinvested.

For example, you may invest $1,000 in a stock that has a compound rate of return of 10% per year for five years. This means that if you reinvest those earnings, the final return would equal $1,610.51 after five years.

It is particularly useful for evaluating long-term investments whereby the returns can be compounded. It gives a more detailed idea of an investment’s return than the simple rate of return, which only considers capital gains and not the effect of reinvesting earnings.

Simple Rate of Return

Simple Rate of Return (SRR) calculates the return on an investment as a percentage of the initial investment amount. It is a straightforward way to measure the profitability of an investment, and it is often used for short-term investments.

The Simple Rate of Return formula is as follows:

SRR = ( Final value – Initial Investment / Initial Investment) x 100

For example, if you buy a stock for $1,000 and sell it for $1,200, making a profit of $200. The Simple Rate of Return for this investment would be:

SRR = ($200 / $1,000) x 100% = 20%

This means that the investment generated a 20% return on the initial investment.

One of the drawbacks of the Simple Rate of Return is that it does not take into account the time value of money, the effects of compounding, or any other factors that affect the RoR over time. Therefore, it isn’t as accurate as other types or measurements such as the CRR. However, its a relatively simple calculation, so is a useful tool for quickly calculating and comparing short-term investments.

Total Rate of Return

Total Rate of Return (TRR) is a financial measurement that shows the overall return over a period of time. It considers all sources of return including price appreciation, dividends, and interest payments.

Expressed as a percentage, TRR calculates not only the increase in value of the investment, but also any income it generates (e.g. dividends and interest). It also considers factors such as the timing of cash flows, such as dividends or capital gains distributions, and reinvestment of those cash flows.

TRR is a useful tool to help evaluate an investments performance as it calculates the total return during the period. By including all factors that bring in a return, it provides a more robust picture.

However, whilst TRR takes into consideration investment returns, it doesn’t calculate various costs. These can range from taxes to transaction costs and should be taken into account when considering different investments.

Factors affecting Rate of Return

1. Time Horizon: long-term investments often have higher potential returns. This is because they tend to level out any ups and downs in the market. However, short-term investments can prove to be less risky. After all, businesses tend to go bust after a relative prolonged period of decline.
2. Risk vs. Return: those investments that provide the best returns are generally those that present the greatest risk. High risk often leads to high reward, but equally, low risk often means low returns. For example, government bonds provide some of the lowest rates of return, but are also one of the safest.
3. Inflation: the power of inflation can erode any investment gains. For example if you have a RoR of 10%, but inflation in 5% – the real RoR is only 5% as inflation has eroded away much of the gains.
4. Taxation: the rate of tax can affect the RoR – especially for items such as capital gains or dividends. These can also vary from country to country, so the RoR can equally vary.
5. Benchmarking: Comparing the RoR of an investment to a benchmark can provide insight into the performance of the investment. Common benchmarks include stock market indexes like the S&P 500 or the Dow Jones Industrial Average.

Compound Annual Growth Rate (CAGR) vs. Rate of Return

Compound Annual Growth Rate (CAGR) and Rate of Return (RoR) are both measures of investment performance, but they are calculated differently and serve different purposes.

RoR is a measure of the gain or loss on an investment over a given period of time, expressed as a percentage. RoR takes into account the initial investment amount and the final value, including any capital gains or losses, dividends, or interest earned. RoR does not consider the time value of money or the compounding effect of reinvesting earnings.

On the other hand, Compound Annual Growth Rate (CAGR) is a measure of the average annual RoR on an investment over a specified period of time, assuming that the investment has been reinvested at the end of each year. CAGR takes into account the compounding effect of reinvesting earnings, which means that the returns earned in one year are added to the investment value and earn returns in the following year. CAGR provides a more accurate measure of investment performance over time, especially when comparing investments with different time horizons.

To summarize, RoR measures the total return on an investment, while CAGR measures the average annual return on an investment over a specific period of time, taking into account the compounding effect of reinvesting earnings.

FAQs

About Paul

Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.

Further Reading

Cottage Industry - Cottage industry refers to small-scale, often home-based, businesses that involve manual labor and traditional production methods to create handmade or…

Coefficient of Determination - The coefficient of determination is a statistical measure that indicates the proportion of the variance in a dependent variable that…

Groupthink: Definition, Characteristics & Examples - Groupthink is the tendency for individuals to agree with each other in a group setting in order to conform and…