Rate of return definition
/What is a Rate of Return?
The rate of return is the percentage increase or decrease in the value of an investment. It is usually calculated on an annualized basis, though other time periods can be used. It can be applied to measure the return on any type of investment, including securities, property, antiques, or even cryptocurrencies. It is a good way to measure the outcome of an investment strategy, as well as to compare the returns on different types of investments.
Formula for the Rate of Return
The formula for the rate of return is to subtract the price paid when an investment was acquired from the price received when it was sold - which is then divided by the acquisition price of the investment. For more accuracy, also subtract any commissions paid or other transaction fees from both the price received and the price paid. The rate of return formula is as follows:
(Price received for investment - Price paid to acquire investment) ÷ Price paid to acquire investment = Rate of return
Example of the Rate of Return
Marcus has invested $100,000 in a local business. After one year, his share of its profits was $10,000. He has experienced a 10% rate of return, which is calculated as the $10,000 of profit divided by the $100,000 investment.
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Problems with the Rate of Return
While the rate of return concept is widely used, there are some problems with it, which are as follows:
Ignores the time value of money. Basic rate of return calculations, such as the accounting rate of return, do not consider the time value of money. This can lead to misleading conclusions about the profitability of long-term investments.
Can be distorted by short-term gains or losses. The rate of return may appear artificially high or low due to short-term market fluctuations or one-time events. This can make it difficult to assess the true performance of an investment over time.
Difficult to compare uneven cash flows. When investments generate irregular or non-uniform cash flows, calculating a meaningful rate of return becomes complex. In such cases, metrics like IRR may give multiple or conflicting results.
Does not account for risk. The rate of return typically focuses on returns alone and does not reflect the level of risk associated with the investment. Two investments may have the same return but vastly different risk profiles, which the metric fails to highlight.
Reinvestment assumptions may be unrealistic. Methods like the internal rate of return (IRR) assume that interim cash flows are reinvested at the same rate, which may not be practical. This assumption can inflate the expected return and misguide investment decisions.