Rate of return (ROR) measures your net gain or loss on an investment over a specified period of time. Generally, ROR is expressed as a percentage of the investment’s initial cost. A positive ROR marks a gain, while a negative ROR marks a loss.
An investment’s rate of return marks your net returns (positive or negative) over a set timeframe. You can apply ROR to any asset that appreciates or produces cash flow, including stocks, bonds, real estate, and more.
You need at least two numbers to calculate an investment’s ROR:
If your investment generates dividends or interests, you’ll need to know that, too.
The standard formula to calculate simple rate of return is:
Rate of Return= Final Value-Initial ValueInitial Value x 100%
Bear in mind that the final value also accounts for “extra” gains, like dividend payments, accrued during your holding period.
The above calculation examines your simple rate of return, otherwise known as your return on investment (ROI). As you might guess by the name, it’s nothing fancy. But it’s not the only ROR equation out there.
For instance, the internal rate of return (IRR) measures the adjusted annualized return based on the timing of the cash flows. A real rate of return adjusts for the impact of inflation.
Let’s take a minute to calculate a simple rate of return of our own.
Say that you purchase 100 shares of Apple for $10 each and hold your shares for two years. During that time, you receive $2 in dividends per share. After two years, you sell all 100 shares for $20 apiece.
To determine your rate of return, you’ll need to know your:
To calculate your initial value, you multiply the number of shares by the price. For our example:
100 shares x $10 purchase price=$1,000 Initial Value
Now, let’s calculate your dividends by multiplying your per-share returns by the number of shares:
100 shares x $2 dividend per share=$200 dividend returns
And the final piece of the puzzle is your current value calculation:
100 shares x $20 sales price=$2,000 Current Value
So, all told, we have:
Now, all that’s left is to plug these values into our formula:
Rate of Return= $2,000+$200-$1,000$1,000 x 100%=120%
All told, your investment in Apple generated a 120% rate of return.
The simple rate of return describes your total gain or loss over a set time period. But you can also examine the annualized rate of return, or Compound Annual Growth Rate (CAGR). As the name suggests, CAGR shows you your annual rate of return.
Calculating your annualized ROR isn’t as simple as multiplying or dividing your simple rate to equal one year. Thanks to compounding, a more advanced equation is required.
The formula for annualized rate of return looks like this:
Annualized Rate of Return= Final ValueInitial Value1time in years-1 x 100%
At first, this formula looks a lot more complex. But once you do it, the calculation is fairly simple. (Just remember to add any accrued gains to your final value.)
Let’s plug in the numbers from the previous calculation for a quick example:
So, our equation would look like this:
Annualized Rate of Return= $2,200$1,00012-1 x 100%=48.32%
Therefore, your investment in Apple. generated an annualized return of 48.32%.
The rate of return on your investments allows you to examine your gains and losses objectively over set timeframes. You can use this information to compare your holdings’ performance against past returns or other investments.
Plus, knowing which investments consistently generate profits or losses can help you decide what to trim come tax-loss harvesting season.
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