Rate of return is the gain (or loss) of an investment in a given time frame, usually expressed as a percentage change over 12 months.
Investors make investments in order to increase the purchasing power of their cash. The only reasonable way to judge the effectiveness of an investment is to calculate its rate of return.
The return is how much extra cash you have after a period of time has elapsed. That number might be negative if the investment declined in value.
To calculate return, compare the value of the investment now vs. its value when the investment was first made. Then calculate the difference as a percentage of the total investment.
Mathematically, the rate of return calculation is the dollar gain minus the dollar cost, divided by the cost.
Comparing investments can be difficult. Stock and bond prices vary from day to day and investors buy and sell them throughout the year.
Nevertheless, it’s important to understand with great certainty exactly how any given investment is doing compared to the alternatives, which might be different investments or none at all.
To complicate matters, inflation constantly eats away at the purchasing power of cash. In addition, many investments generate taxes, another drag on return. Don’t forget to add in trading fees, too.
Finally, serious investors must accurately judge the amount of risk they take with one investment compared to another. Two investments might return the same percentage gain but at very different levels of risk.
Investment pros do this in a simple way by comparing the dollars invested on one date to the dollars earned (or lost) an another. For comparison’s sake, they do this in predictable periodic segments, such as quarters and years.
The calculation isn’t any more complex than subtracting the “now” from the “then” and dividing by the “then.”
For instance, if you have an investment that is worth $100 today and for which you paid $50 one year ago, you know that the return was 100%. You doubled your money.
Now, let’s complicate matters. Unless you own a tax-free or tax-deferred investment, you will owe taxes on the gain now. Assume it’s a long-term gain tax of 20%. So that’s $10 less.
You almost certainly paid a fee for buying and selling that investment. If you used a discount broker and did it yourself, perhaps that was $7 to buy and $7 to sell.
Now you’re down $24 on your $50 gain. But there’s more.
Inflation never sleeps. Your $50 is not worth $50 one year later. Annualized inflation of about 3% means lopping off another $1.50 in purchasing power.
All in, you made $50 but lost $27 of that gain to taxes, fees and inflation. Your $50 turned into $73 after one year, meaning your rate of return is really 46%, rather than 100%.
Not quite doubling your money anymore, all things considered. All this leaves aside the complications of calculating risk, which is a science unto itself.
MarketRiders, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.