Knowing how well your investment performs is crucial in understanding if you’ve made a good purchase. One of the most common ways to evaluate investments is by finding out its rate of return. This is the net gain or net loss of an investment during a period of time. A rate of return is a percentage, positive or negative, of the initial cost of the investment. This percentile change is what is referred to as the rate of return (RoR).
As an investor, it is important to understand what RoR is and how to assess it. Any of your investments can be assessed this way, including stocks, bonds, or real estate. When thinking about an investment and assessing its RoR, investors look at rates of return from a past point in time and compare them to current similar assets to help evaluate the best performing investment. As you study and understand your investments more fully, you will begin to set requirements on the rate of return for your holdings.
There are several different formulas for evaluating the real rate of return, but the simple formula looks at the basic growth rate of your asset. This is also known as the return on investment or ROI. It would look like this:
[(Current value – Initial value)/Initial value] x 100 = Rate of Return
One of the considerations that this simple formula doesn’t take into consideration is inflation. The value and purchasing power of money is impacted by inflation. $10,000 in 1920 is not the same as $10,000 in 2020. If you only consider RoR without assessing inflation, you would be determining your nominal rate of return. When determining the real rate of return, you must take into consideration how your money’s value will be affected by inflation over time.
For real estate investments, you will utilize a mortgage calculator. If your intentions are to rent your property, you evaluate your income, expenses, and initial costs to help determine your ROI. When you’ve determined these figures, you can plug them into a formula to calculate your estimated percentage. You’ll also need to know your initial investment—the final value you spent on the down payment, rehab, closing costs, and all other upfront expenditures—to determine ROI. The equations to figure this out would be:
Income – Expenses = Cash Flow
(Cash Flow x 12)/Initial Investment = ROI
Calculating RoR on stocks and bonds varies from this. A big part of this is due to dividends. Let’s say you purchased a stock for $100. You held this stock for three years, over which period its value came to $135. During this time, you also earned $15 in dividends. You decide to sell the stock at $135 per share netting $35 ($135 – $100) and also earned $15 in dividends making your total gain for the stock $50. Your initial investment was $100, thus making your RoR 50%.
The final rate of return I want to bring to your attention factors in the compound annual growth rate (CAGR). The CAGR determines the mean annual rate of return during specific periods of time over a year. It aims to calculate growth throughout several periods of time.
CAGR is determined by dividing the investment’s value at the end of a specific period by its initial value during the same period. That number is then raised to the power of one and divided by the number of periods you are evaluating minus one.
Calculating RoR can help you to make determinations on your portfolio, evaluate the historical return on potential investments, and determine the cash flows for your assets. It’s good to regularly check your RoR to make sure your investments are continuing to produce the rate of return you expect from them.