What Is Rate Of Return?

Gains or losses that come from an initial investment over a set period of time are known as the rate of return. Also known as ROR, it’s usually expressed as a percentage of your initial investment. A positive rate of return means an investment has increased in value, while a negative rate of return means the value has declined.

The rate of return can be a helpful way to gauge how profitable an investment is over a chosen period of time. You may choose to compare a single investment’s performance over time or focus on comparing returns from different investments.

Ways To Measure ROR

There are multiple approaches to measuring rate of return. There are slight nuances between each approach and which type you use depends on your goals.

• Nominal rate of return: The amount of money an investment generates excluding inflation or taxes. As a result, the calculation has limitations
• Annual rate of return: How much an investment’s value has changed over the course of a year, expressed as a percentage
• Money weighted rate of return: Calculates your investment performance while including factors like cash flow (includes investments and withdrawals) and how that affects a portfolio’s returns
• Time weighted rate of return: Measures investment performance over a certain period excluding factors like cash-flow
• Internal rate of return: Measures the expected annual growth of an investment. Also known as the discounted cash flow rate of return and can be useful when measuring potential returns for real estate investments
• Total return: Factors interest, dividends, and any capital gains from an investment
• Real rate of return: he annual rate of return but it’s adjusted for inflation

Rate of Return Calculation

There are various calculations for rate of return depending on which type you’re targeting. However, the standard calculation for rate of return is:
R = [ ( Ve – Vb ) / Vb ] x 100

In terms of what each letter stands for,
R = Rate of return
Ve = End of period value
Vb = Beginning of period value

For example, if you were an investor and decided to buy stock at $200 per share, that initial amount you invested would be the Vb or beginning of period value. If after a year, each share went from $200 to $250 and you decide to part ways with the shares, the end of period value or Ve would be $250.

If you wanted to calculate your rate of return using the example above, the formula would look like this:
[ ( $250 – $200 ) / $200 ] x 100 = 25%

$250 minus $200 is $50. When you divide $50 by $200, you get 0.25. Multiply that by $100 and you get 25%.

There are other formulas for other types of ROR, like the annual rate of return for instance, which you’ll see below.

Calculating Annual ROR

The annual rate of return is similar to the rate of return-the only difference is that you measure net gains or losses over a single year.

The formula looks like this:
Annual Rate of Return % = [(End of year price – Beginning of year price) / Beginning of year price] x 100

As you can see, the main difference between this formula and the one above is that you input the end of year price instead of the end of period value.

For example, if you purchased an investment for $70 at the beginning of the year and it rose to $90 by the end of the year, the rate of return would be 28.57%.

$90 – $70/$70 x 100 = 28.57%

To break this down. $90 – $70 is $20. When you divide that by $70 you get 0.2857. Multiply that by $100 and you get 28.57%.

Using ROR In Investing

Before investing, you can calculate ROR and use your findings to inform your decision about what to invest in. For instance, you may look at the rate of return on a certain stock or bond over the past decade.

The ROR can be used on just about any common investment be it stocks, real estate, mutual funds, or art. Businesses can also use ROR as a tool to assess how to use their capital.

Investors should know that ROR has its limitations. For instance, it doesn’t take the time value of money into consideration. Time value is the idea that money is worth more now than it will be in the future because of factors like opportunity cost, inflation, and uncertainty. Another limitation is that Comparing ROR has flaws seeing as some investments take longer to realize profit than others.