As an investor, it’s important to understand how your investments perform over time. Otherwise, it can be difficult to make informed decisions about your portfolio. Rate of return is one metric that could help bring asset performance into focus. Here’s how rate of return works, why it matters, and how to calculate it—plus the pros and cons of relying on rate of return, as well as alternative metrics that could help you.
What is rate of return (RoR)?
Rate of return (RoR) is a measure of an investment’s gain or loss over a specified period of time. Expressed as a percentage of the initial investment cost, RoR can help evaluate the performance of any investment type, including stocks, bonds, real estate, and more.
Why is rate of return important?
Rate of return is important because it’s a quick way to help determine whether an asset or portfolio has been performing well. This is a key input when deciding whether to buy, sell, or hold different investments.
How does rate of return work?
Rate of return takes the following factors into account, all of which provide insight about an asset’s performance:
- The time period you’re focusing on
- The asset’s cost at the beginning of that period
- The asset’s current value
Any payments you’ve received (such as interest or dividend payments) can be factored in using a slightly different formula.
Rate of return formula
Here is the formula used to calculate a basic rate of return:
(Current value – initial value)
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Initial value
Multiply that number by 100 to get the annual RoR as a percentage.
How to calculate rate of return
Here’s an example of how to calculate rate of return. Let’s say you purchased a stock for $500, and it’s trading at $600 a year later. Your 1-year rate of return would be calculated as follows:
[($600 – $500) / $500] x 100 = 20%
If the asset instead decreases in value during a given time period, your rate of return would be negative. For instance, if you bought a stock for $500 and it’s worth $450 a year later, your 1-year rate-of-return calculation would be:
[($450 – $500) / $500 ] x 100 = –10%
How to calculate rate of return for income-yielding assets
The rate-of-return formula is a little different for assets that have generated income while you’ve held them. That can happen with:
- Dividend-paying stocks
- Income-generating mutual funds and ETFs
- Certificates of deposit (CDs)
- Interest-bearing bonds and real estate investment trusts (REITs)
- Rental properties
In this case, the RoR formula looks like this:
[(Current value – initial value) + payments received]
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Initial value
Again, you’ll multiply the result by 100 to find the annual rate of return percentage.
Here’s that formula in action. Let’s say you bought a stock for $1,000 and after a year of holding it, its current value is $1,200. Over the course of the year, the stock paid you $30 in dividends. In this scenario, your 1-year rate of return would be:
{[($1,200 – $1,000) + ($30)] / $1,000} x100 = 23%
Advantages of rate of return
Using this metric has some key benefits:
- Simplicity: Calculating rate of return is easy. All it requires is a few inputs and a calculator.
- Versatility: Rate of return can be used for virtually any type of investment, whether or not they generate income before selling the asset.
- Comparability: By calculating rate of return for multiple investments, you can quickly compare their performance. This could help you determine which asset belongs in your portfolio.
Disadvantages of rate of return
However useful rate of return can be, it also has drawbacks. It doesn’t account for:
- Risk: For example, cryptocurrency has a different risk profile than an index fund, even if the rate of return for each is identical for a given period. Over-relying on rate of return could cause someone to invest counter to their risk tolerance.
- Taxes and fees: Rate of return doesn’t factor in trading fees or taxes, including capital gains taxes or taxes on dividends or interest, which will reduce an investment’s real return.
- Inflation: Inflation can also eat away at total returns. It diminishes your earnings’ purchasing power, especially if inflation outpaces the rate of return.
Rate of return vs. real rate of return
So far, we’ve looked at simple rate of return (aka nominal rate of return), which doesn’t account for inflation. Real rate of return, on the other hand, does consider inflation. This may give you a more accurate idea of how an asset has performed over time relative to your purchasing power. To find the real rate of return, subtract the inflation rate from the simple rate of return. For example, if the simple rate of return is 10%, and inflation was 3% during that time period, the real rate of return would be 7%.
Rate of return vs. compound annual growth rate (CAGR)
If you’ve held an asset for years, calculating its compound annual growth rate (CAGR) can be beneficial. This is the average annual return over any period that exceeds 1 year. If you calculated the asset’s rate of return over the total period you owned it, it would be hard to understand how it truly compares to growth rates for assets you’ve held for shorter periods of time. That’s where CAGR comes in, giving you an apples-to-apples comparison, annualizing the average rate of return. In the following formula, the “n” represents the number of years in a given period:
CAGR = {[(Ending Value / Beginning Value) ^(1 / n)] – 1} x 100
The CAGR formula can look overwhelming, so here’s a breakdown:
- Divide the investment’s ending value by its beginning value.
- Raise that number to the value of 1 divided by n (the number of years).
- Subtract 1 from the resulting value.
- Multiply your final answer by 100 and add a percentage sign.
How to use rate of return with your investments
While past performance doesn’t guarantee future results, using rate of return to understand an investment’s performance can still be a useful data point. Along with metrics that evaluate risk and earnings lost to fees, rate of return can help you:
- Decide if an investment deserves a spot in your portfolio.
- Figure out how much of that investment to buy.
- Evaluate whether an asset you own is performing in a way that supports your financial goals—and whether you might want to sell it or buy more.
- Compare an asset’s performance to other investments to determine which may best help you reach your goals. You may want to compare the rate of return of a benchmark, such as the S&P 500®1 index, to the investment in question’s rate of return.