Calculating the Rate of Return on InvestmentsLet's say you invest $100 in stock, which is called your capital. One year later, your investment yields $110. What is the rate of return of your investment? We calculate it by using the following formula: ((Return - Capital) / Capital) × 100% = Rate of Return Therefore, (($110 - $100) / $100) × 100% = 10% Your rate of return is 10%. There are two ways to measure the rate of return on an investment.
A simple example below will show what these two yardsticks measure.
You initially invest $100. One year later, your investment grows to $200 in value. The year after that, the investment drops back to $100. The rate of return after the first year is ((Return - Capital) / Capital) × 100% = Rate of Return (($200 - $100) / $100) × 100% = 100% The rate of return after the second year is (($100 - $200) / $200) × 100% = -50% By using the formulas for calculating the average annual rate of return, we get a
percentage that measures gains accurately over only a short period. Whereas, the geometric
or compound rate of return is a better yardstick to measure your investment over the long
run. The arithmetic mean or average return should be used to calculate return on
investment only in the short-term.
Note : Mutual fund managers report the average annual rate of return (arithmetic) on
the investments they manage. As shown in the above example, the arithmetic return of the
investment is 25%, even though the value of the investment is the same as it was two years
ago. Thus, mutual fund reports are somewhat deceptive. Stock Learning Center | Stock
Indexes
|
Average annual rate of return (also known as average
annual arithmetic return)
