What to Do
At its most straightforward, the formula for rate of return is very simple:
Example:
An investor puts $2,500 into a particular stock. Twelve months on, it’s worth $2,900. The calculation looks like this:
Rate of return can also be used to track an investment over a longer period. For example, suppose our investor finds that during the second year the value of the investment drops to $2,700. The annual rate of return is now:
But if the investor calculates the average annual return (also known as “average annual arithmetic return”), it shows that overall the investment has gained:
So:
Bear in mind that the average annual rate of return becomes less precise over a longer period. For a more meaningful long term measurement, investors might prefer to use the “geometric” or “compound” rate of return, which is a more complex formula taking into account the effect of reinvesting the yield.
What You Need to Know
- For a more accurate figure, rate of return should be adjusted for inflation. For example, if inflation is at 3%, then a rate of return of 8% is really only worth 5%.
- Rate of return is not the same thing as the more complex formula known as “internal rate of return.”
- If an investment report shows an average annual rate of return, take care. An average rate could mask a recent decline in value, so look for the figures behind it.
Where to Learn More
Web Sites:
Investopedia (search for “return on investment”): www.investopedia.com
Rate of return calculator (more complex formulae): www.numericalexample.com/content/view/38/27
