Understanding Investment Total Rate of Return Formula

What Is a Rate of Return (RoR)?

A rate of return (RoR) is the gain or loss of an investment over a specified period of time, expressed as a percentage of the investment's cost. It is an important metric that investors use to evaluate the profitability of an investment.

The Formula for RoR

The formula for calculating the rate of return is:

RoR = (Ending Value - Beginning Value) / Beginning Value * 100%

Where:

• RoR is the rate of return
• Ending Value is the value of the investment at the end of the specified period
• Beginning Value is the value of the investment at the beginning of the specified period

RoR on Stocks and Bonds

The rate of return on stocks and bonds is calculated in the same way as the general formula. However, it is important to consider the dividends and interest payments received during the investment period. These payments should be included in the ending value of the investment.

Real Rate of Return vs. Nominal Rate of Return

The real rate of return takes into account the impact of inflation on investment returns, while the nominal rate of return does not. The real rate of return provides a more accurate measure of the purchasing power gained or lost on an investment.

Real Rate of Return vs. Compound Annual Growth Rate (CAGR)

The compound annual growth rate (CAGR) is a measure of the annual growth rate of an investment over a specified period. It is similar to the rate of return, but it considers the compounding effect of investment returns. The CAGR is often used to compare the performance of different investments over a long-term period.

Example of RoR

Let's say you invested $10,000 in a stock and sold it a year later for $12,000. The rate of return would be:

RoR = ($12,000 - $10,000) / $10,000 * 100% = 20%

Internal Rate of Return (IRR) and Discounted Cash Flow (DCF)

The internal rate of return (IRR) and discounted cash flow (DCF) are alternative methods for evaluating the profitability of an investment. These methods take into account the time value of money and provide a more accurate measure of the investment's return.

What Are Some Alternatives to the Rate of Return?

Some alternatives to the rate of return include the IRR, DCF, and CAGR. These methods provide a more comprehensive analysis of an investment's profitability.

What Are Some Drawbacks of RoR?

There are some drawbacks to using the rate of return as a measure of investment profitability. It does not take into account the timing and magnitude of cash flows, and it does not consider the risk associated with the investment.

What Is Considered a Good Return on an Investment?

A good return on investment depends on various factors such as the risk level of the investment, the time horizon, and the investor's goals. Generally, a higher rate of return is desirable, but it should be balanced with the associated risks.

The Bottom Line

The rate of return is a crucial metric for evaluating the profitability of an investment. It provides investors with a clear understanding of the gain or loss on their investments. However, it is important to consider other factors such as risk, timing, and cash flows when making investment decisions.