Rate Of Return: Definition And How To Calculate It

Every investment has what is called a rate of return. The rate of return measures how successful a given investment is, and it can be a great way to help you decide between many different investments. Simplifying an investment to its rate of return can make it easier to compare investments that have different durations or levels of risk.

What Is A Rate Of Return?

At its simplest, the rate of return measures the amount of profit (or loss) of an investment as a percentage of the total amount invested. A positive rate of return signifies a profit on an investment, and a negative rate of return means that the investment carried a loss. Every investment has a different amount of risk and might last for a different amount of time.

Rate Of Return Vs. Return On Investment

An investment's internal rate of return (IRR) and return on investment (ROI) both measure how an investment performs. The return on investment is a simple calculation that takes the total profit or loss of an investment divided by the total amount invested. An investment's rate of return measures how an investment performs over time.

Positive Vs. Negative Rate Of Return

A positive rate of return indicates that the investment made money, while a negative rate of return indicates a loss.

How To Calculate Rate Of Return: A Formula

The rate of return formula is:

(Final Value - Initial Value) / Initial Value * 100

Here is an example: If you invest $10,000 in the stock market and the investment is now worth $12,000, your rate of return is 20%. That's $12,000 - $10,000 or $2,000, divided by your initial investment of $10,000 and multiplied by 100 to turn the rate of return into a percentage.

Rate of Return Calculator

If you’re interested in how to calculate rate of return, you may be looking for a rate of return calculator. There are many different rate of return calculators out there — here is one example. This tool will allow you to find the annual rate of return of an investment by putting in the start and end date of the investment and how much was invested initially. You can also see how your rate of return is affected by periodic withdrawals or deposits.

Additional Measurements For ROR

Total Return

An investment's total return is another way to measure rate of return. Total return also includes any interest, dividends or capital gains earned by the investment. This means it will usually be the same as or higher than the simple rate of return and can give a more accurate look at the performance of an investment.

Annualized Rate Of Return

An investment's annualized rate of return is also known as the Compound Annual Growth Rate (CAGR). The annualized rate of return equation is:

((Ending Value / Beginning Value) ^ (1 / # Of Periods)) – 1.

So for example, an investment of $10,000 that goes up to $16,000 over the course of 3 years has a CAGR of 16.96%.

Nominal Rate Of Return

The nominal rate of return is the amount of money created by an investment before adding other expenses. With many investments, you may have additional expenses such as taxes, investment fees or other expenses. To calculate the nominal rate of return, you'll want to subtract out these fees first. When calculating the nominal rate of return, it's important to use the current market value and original investment value for the calculation.

Internal Rate Of Return (IRR)

The internal rate of return of an investment is also known as the discounted cash flow rate of return (DCFROR). The internal rate of return of an investment is a way to measure the annual growth that an investment is expected to generate. This can be useful to calculate the rate of return of an initial investment that’s expected to generate cash flow over time, like rental real estate.

The internal rate of return formula is fairly complicated, and not easily calculated by hand. However, there are many tools such as Excel that have built-in formulas to calculate IRR. You'll want to use the net present value, net cash flow, total initial investment costs and the number of time periods for the calculation.

How To Use Rate Of Return

Here are some brief examples of how to find the rate of return on common types of investments.

Stocks

Investing in stocks is a popular way to save for retirement or the future. The rate of return formula for investing in stocks is the total profit on the investment divided by the initial amount invested. So, if you invest $5,000 in the stock market and those investments are now worth $6,000, the rate of return on your investment is 20%.

Bonds

Bonds are a long-term investment designed to be less risky than stocks or other investments. This is because most bonds are backed by the full faith of the United States government. A $50 savings bond can be generally purchased for $25 and won't be worth its full value of $50 for several years. Its overall rate return would be 100% over the length of the investment, though it may be more useful to calculate an annualized rate of return.

The Bottom Line: Rate Of Return Measures Growth And Loss

Rate of return helps measure how much money was gained or lost during a period of time. It can be a great way to compare different investments and to help you understand where you should invest your money each month. The rate of return can be either positive or negative, with a positive rate of return meaning an investment made money and a negative value indicating a loss.