What Does Rate of Return Mean?
Rate of return is defined as the amount of money that an investment earns by way of interest, dividend or any other form of cash flow. This return is obtained by the investor during the period of investment or at the end of it, depending on the terms and conditions entered into at the time of investment. The rate of return is always expressed as a percentage and it is calculated as:
Rate of return = (Final value of the investment including dividends and interest - Initial value of the investment) / (Initial value of the investment)
The above formula applies only when an investment is for a single period. In the case of continuously compounded returns, the formula is:
r log = ln(Final value of the investment / Initial value of the investment) / (Time)
r log = the logarithmic rate of return
ln = the inverse
To compute the returns over multiple years, the mathematical average of each year is taken.
Divestopedia Explains Rate of Return
Rate of return can also be seen as a profit made from an investment over a certain period of time. If the period of investment is for one year, then the rate of return is called the annual return. Rate of return does not always have to be positive. If it is negative, then it is termed as a loss or a negative return obtained from the investment.
The rate of return from an investment reflects the amount of risk involved in an investment. In general, safe investments, like US Treasury bonds, give a lower rate of return when compared to riskier investments, like shares, that give a higher rate of return. In fact, the rate of return will be commensurate to the level of risk involved.
The rate of return is an important measure to determine whether a particular investment is sound or not. If there are two investments and an investor has only a limited amount of money that can be invested in only one, then the rate of return helps to make the decision of which to choose. Other factors, like risk and personal preferences, may also be considered, but it is the rate of return that can be the decision clincher.