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The simple way to measure the growth of your investments.
If you’ve profited from an investment — made some money from a bond or the stock market — you might be looking for a way to measure how much you earned. Calculating the rate of return is the simplest way to compare the growth on your investments.
Also known as return on investment, rate of return is how much an investment has lost or gained over a specific period of time. A positive number indicates a gain, while a negative number indicates a loss.
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You can calculate the rate of return for any investment that has a measurable initial value and final value, including bonds, stocks, and even gold and real estate. The final value of an investment includes any dividend payments or coupon earnings. The initial investment value should include all costs of capital, or necessary costs to make the investment, like fees and taxes.
Rate of return = (final value of investment - initial value of investment) / initial value of investment *100
Example: You purchase 10 shares of stock at $10. You sell the shares after three years at $14 per share. You also received yearly dividends of $1 per share.
The initial value of your investment, or cost of capital, is the $100 used to purchase the stocks. The final value of your investment is $170 ($140 from the sale, plus $30 in dividend payments).
Plugging into the formula above:
Rate of return = ($170 - $100) / 100 * 100
Rate of return = 70%.
The simple rate of return formula above tells you how much your investment grew over the entire time you had it, but it does not tell you how much your investment grew from year to year. For that you need to find the annualized rate of return, or compound annual growth rate (CAGR). This shows the growth rate of your investment if it grew at the same annual rate and if you reinvested the profits every year.
Annualized rate of return = final value of investment/initial value of investment)^(1/ number of years) - 1 *100
Using the example in the previous section:
Annualized rate of return = (170/100) ^ (⅓) - 1 * 100
(1.7) ^ (⅓) - 1 * 100 = 19.348%
As you can see, the 19.348% annual rate of return on your stocks is much smaller than the simple rate. Keep in mind that the amount of money you made is still the same; the annual rate just gives you a different way of looking at your growth.
Rates of return provides a quick, at-a-glance way to measure how much an investment grew. It works for different types of investments and gives you a simple way to compare your investments.
The compound annual growth rate is handy when you want to more objectively compare rates of return on investments of varying lengths. For example, it’s useful if you wanted to compare the earnings on a three-year-old stock with your earnings on a five-year-old bond.
At the same time, rates of return and the above formulas can prove too simplistic in some cases. For certain long-term investments, there may be more grey area when figuring out the costs of the initial investment value, which will make it more difficult to calculate the rate of return.
There is no one such measure of a good rate of return as the rate of return depends on the type of asset you have. Riskier investments might yield higher returns, but their volatility can also leave you with even less than what you started with.
Certificates of deposit (CDs) and bonds with fixed rates, for example, will yield steady growth. On the other hand, the returns on real estate or gold can vary, and what constitutes a good rate will depend on your circumstances and expectations. The average annual return on a treasury bond is around 3%, while the stock market historically has returns of between 7% and 10% per year.
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The internal rate of return, or discounted cash flow rate of return (DCFROR), is another way to evaluate investment performance by taking into account the time value of money. This is the idea that having money in hand now is worth more than receiving that same amount of money later because you have the potential to invest and earn more if you have the money now.
Along with return on equity (ROE), which measures the profitability of a business, and return on assets (ROA), how profitable a company is compared to its total assets, internal rate of return is another way to measure investment performance. With a more complex formula, internal rate of return is primarily frequently used by businesses and serious investors to evaluate the profitability of a potential investment or project.
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