Rate of Return: Types & Calculation

Definition

The rate of return (RoR) is a financial metric used to evaluate the profitability or performance of an investment over a specific period of time.

What is rate of return?

Rate of return is expressed as a percentage and provides insight into the gain or loss generated from an investment relative to the initial amount invested.

There are several types of rates of return, each serving different purposes:

Simple rate of return: The simple rate of return is the most basic form of measuring investment performance. It is calculated using the following formula:Simple RoR = (net profit / initial investment) x 100%

Annualised rate of return: The annualised rate of return accounts for the time value of money and is useful for comparing investments with different time horizons
Total rate of return: The total rate of return encompasses all forms of return from an investment, including capital appreciation, dividends, interest, and other income. It is expressed as a percentage and is calculated using the following formula:Total RoR = (total gain / initial investment) x 100%
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Risk-adjusted rate of return: This metric factors in the level of risk associated with an investment. It’s important because higher returns often come with higher risk.

Understanding the rate of return is crucial for investors, as it allows them to assess the performance of their investments, compare different investment opportunities, and make informed decisions about where to allocate their capital.

Example of rate of return

John purchases 100 shares of stock in Company XYZ at €50 per share, investing a total of €5,000. One year later, he sells the shares for €60 each.

Now we can calculate the rate of return:

Gain = (€60 x 100) – (€50 x 100)

Gain = €6,000 – €5,000 = €1,000

Rate of return = (€1,000 / €5,000) x 100% = 20%

In this example, John’s rate of return on his investment in Company XYZ is 20%. This means he earned a 20% profit on his €5,000 investment over one year.