The rate of return is a basic measure used to calculate the performance of an investment and compare it with other investment options. It is the percentage change in the value of the investment over a period of time.
Definition of Rate of Return (RoR)
The rate of return is the profit or loss of an investment over a specified period expressed as a percentage. The U.S. Securities and Exchange Commission (SEC) defines the annual rate of return as “the percentage change in the value of the investment.” The rate of return can be defined over any time period such as daily, weekly, monthly, or annually, but is most often referred to as an annual rate.
Note: The rate of return can be defined as a positive percentage or a negative percentage in the case of a loss. To calculate the rate of return, the net profit must be divided by the initial balance and multiplied by 100 to obtain the growth (or loss) percentage of your investment.
Suppose you invested $5,000 in an exchange-traded fund (ETF). After one year, this amount grows to $5,500, yielding a total net profit of $500 with a positive annual rate of return of 10%. Conversely, if you put $5,000 in an exchange-traded fund and after one year it becomes worth $4,500, then the total loss is $500 and the negative annual rate of return is 10%.
How the Rate of Return Works
To calculate the rate of return, all we need to know is the initial balance and the final balance of your investment. This will determine your net profit or loss, which you should then divide by your initial investment and multiply by 100 to express it as a percentage. The formula for the rate of return is as follows:
Let’s break down the equation with a detailed example. Jane decides to invest $100,000 in stocks, divided among her top 10 preferred companies. After a year of holding these ten stocks, she finds that her stock portfolio is now worth $112,000. To calculate Jane’s rate of return, we need to determine her net profit or loss and divide it by her initial investment. Here’s how we will calculate Jane’s rate of return:
Calculating her net profit or loss: 112000 – 100000 = $12000 net profit
Dividing the net profit or loss by the initial investment: 12000 / 100000 = 0.12
Multiplying 0.12 by 100 to get a percentage: 0.12 × 100 = 12%
Jane invested $100,000 in the stock market which grew to $112,000, resulting in a profit of $12,000. The growth of $12,000 from an initial investment of $100,000 equals a rate of return of 12%.
Alternatives to Rate of Return
There are alternative rates you can use, all based on the basic formula of rate of return. Some of them include Internal Rate of Return (IRR) and Compound Annual Growth Rate (CAGR).
Internal Rate of Return
The Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of the cash flows of an investment equal to zero. If you expect the investment to generate returns over the next five years, we take these returns for each of the five years in succession and discount them to their present values. The rate required to discount the cash flows to zero is the internal rate of return.
Note: The formula for calculating the internal rate of return is very complex and often requires a calculator or software.
Compound Annual Growth Rate
The Compound Annual Growth Rate (CAGR) is the annual growth rate of an investment considering the effects of compounding interest. The formula for calculating CAGR is as follows:
CAGR = (Ending Balance / Beginning Balance)^(1 / Number of Periods) – 1
If you invested $1,000 and after five years it became worth $1,500, you would have a rate of return of 50%. However, your compound annual growth rate would be 8.45% compounded annually over the five years.
Return
Return on Equity
When investing in stocks, the Return on Equity (ROE) can be useful in determining whether a company is using your invested funds effectively. ROE calculates the amount of profit that a company generates relative to shareholders’ equity. To calculate ROE, the net profit is divided by total shareholders’ equity. This is the formula format:
ROE = Net Profit / Shareholders’ Equity
Return on Assets
Return on Assets (ROA) calculates a company’s total profit relative to its total assets. Assets include anything like cash, equipment, inventory, real estate, machinery, and so on. The formula for calculating ROA is as follows:
ROA = Net Profit / Total Assets
What This Means for Individual Investors
The rate of return is a powerful tool for investors to quickly assess investment performance. It is useful for comparing and anticipating potential investment products. Whether you are investing for retirement, higher education, a down payment on a home, day trading, or building wealth, using the rate of return will provide you with better insight into investment growth. This way, you can make decisions accordingly.
The Takeaway
– The rate of return (RoR) is the profit or loss on an investment over a specified period of time expressed as a percentage.
– You can calculate the rate of return by taking the net profit and dividing it by the initial investment, then multiplying by 100 to convert it to a percentage.
– There are alternatives to the rate of return such as Internal Rate of Return (IRR), Compound Annual Growth Rate (CAGR), Return on Equity (ROE), and Return on Assets (ROA).
– The rate of return allows investors to assess investment performance, compare investments, and even predict potential investments.
Source: https://www.thebalancemoney.com/what-is-rate-of-return-ror-5195066
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