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Measuring Rate of Return

Updated on: May 2, 2007 / 6:54 PM EDT / MoneyWatch

Rate of return (also known as "yield" or "return on investment") is the annual percentage gain—or loss—of an investment or fixed-income security.

Rate of return is useful for making basic comparisons between investments. Together with more specific information—like individual aims and the level of acceptable risk—it can help investors make the most appropriate choices.

The calculation is also used in financial management for information such as return on assets, equity or sales—essential for assessing the performance of any business.

What to Do

At its most straightforward, the formula for rate of return is very simple:

[(current value of investment – original sum invested) / original sum invested] × 100 = rate of returnExample:

An investor puts $2,500 into a particular stock. Twelve months on, it's worth $2,900. The calculation looks like this:

[(2,900 – 2,500) / 2,500)] × 100 = 400 / 2,500 × 100 = 16% rate of return

Rate of return can also be used to track an investment over a longer period. For example, suppose our investor finds that during the second year the value of the investment drops to $2,700. The annual rate of return is now:

[(2,700 – 2,900) / 2,900) × 100 = –6.9% rate of return

But if the investor calculates the average annual return (also known as "average annual arithmetic return"), it shows that overall the investment has gained:

(rate of return for Year 1 + rate of return for Year 2) / 2 = average annual return

So:

(16 +- 6.9) / 2 = 4.55% average annual return

Bear in mind that the average annual rate of return becomes less precise over a longer period. For a more meaningful long term measurement, investors might prefer to use the "geometric" or "compound" rate of return, which is a more complex formula taking into account the effect of reinvesting the yield.

What You Need to Know

For a more accurate figure, rate of return should be adjusted for inflation. For example, if inflation is at 3%, then a rate of return of 8% is really only worth 5%.
Rate of return is not the same thing as the more complex formula known as "internal rate of return."
If an investment report shows an average annual rate of return, take care. An average rate could mask a recent decline in value, so look for the figures behind it.

Where to Learn MoreWeb Sites:

Investopedia (search for "return on investment"): www.investopedia.com

Rate of return calculator (more complex formulae): www.numericalexample.com/content/view/38/27