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How to calculate the Rate of Return on investments
Financial Literacy
Key takeaways:
- How to calculate the rate of return on investments starts with comparing an asset’s current value with its initial value to measure profit or loss as a percentage. This gives a simple way to assess how much an investment has appreciated or depreciated over a given period.
- The rate of return becomes more useful when it includes cash flows and costs, not just price changes. Dividends, interest, brokerage fees, taxes, inflation and other holding costs can materially affect the real return on investment.
- Different types of rate of return calculations help investors build a more accurate picture of portfolio performance. A basic calculation shows headline growth, while broader calculations can reflect the real rate of return after adjusting for expenses and other factors that reduce net gains.
- The rate of return for different assets must be calculated with the right inputs for each investment type. Stocks may include dividends and fees, bonds may include interest income and sale gains, and real estate may require maintenance costs, taxes, fees and rental income to be factored in.
- The advantages of using rate of return calculations are that they are quick, practical and useful for comparing investments, but the disadvantages are equally important. Rate of return methods can vary, some costs may be excluded, and RoR alone does not capture every factor that matters when evaluating an asset.
At the heart of it, many people invest in the hope of making a profit. This can happen when the value of the invested asset appreciates over time and/or generates cash flows (such as interest, dividends, or rent). If the asset depreciates over time, then it has lost value and the investor has made an overall loss. But how do we calculate exactly how much has been made or lost from an investment?
The standard approach here is to calculate what is known as the Rate of Return (RoR).
This is a simple, widely used calculation that can help estimate an investment’s percentage gain or loss before adjusting for items such as fees, taxes and inflation.
Within this calculation, there are also additional ways to get a better picture of your asset's financial health. For example, you can run a real rate of return calculation to determine the real value of your investment after factors like inflation are taken into account.
If you're wondering exactly how you can use the calculation to stay on top of your portfolio and make more informed and empowered investing decisions, keep reading for a complete guide on how to calculate the RoR. But always remember, investing involves risk. You may lose some, all, or more than your initial investment.
What exactly is the Rate of Return?
The RoR calculation can be used to measure the price appreciation or depreciation of any asset over a certain period of time, as long as you can observe a starting value, an ending value, and any cash flows received during the period (such as dividends or interest).
At the most basic level, you can calculate the RoR by comparing the current value of an asset to the initial value of that asset when you first bought it. By doing this, you can work out an exact percentage figure that shows how much the asset has grown or fallen in value since you made the investment.
This percentage shows the percentage gain or loss on your asset. Investors often use RoR to monitor portfolio performance and compare investments. That is why it is common for investors to seek out estimated rates of returns on various assets before they make a trade.
Such estimates are never a sure thing, but they are often based on current market conditions and projected growth figures for a particular asset market. By understanding the RoR, you can better track the performance of your portfolio and select assets that offer the best chance of realising profits further down the line.
What is an example of the Rate of Return formula, in application?
Let's run through a standard RoR calculation: in this basic example, we won't be looking at factors such as dividends, brokerage fees, and inflation, even though these have a significant impact on the real returns on investment.
To start, let's assume you paid USD 10,000 for a painting in 2012. This year you plan on selling the painting. You have had the painting evaluated and were told that it is now worth USD 15,000 since the artist who painted it is now highly sought-after. To calculate the basic rate of return on your painting, we can use the following calculation:
Rate of Return = ((current value of asset - initial value of asset) ÷ initial value of asset) x 100
So, to calculate the RoR for your painting, it would be 15,000 - 10,000 (5000), divided by 10,000 (0.5) x 100 = a +50% return on investment. Not too bad.
What are the different types of rate of return calculations?
Of course, the straight-up price change does not always tell us everything we need to know about the RoR. It is also important to take into account any costs that the investor has incurred as a result of acquiring and holding the asset, as well as any additional gains from that asset during the holding period, such as dividends. In order to take these into account, additional inputs must be added to the original rate of return calculation.
Let's walk through another example to show how this works:
- Let's say you bought USD 10,000 worth of shares with your trading account at the beginning of last year. Now, let's say that those shares were valued at USD 14,000 at the end of the year.
- In addition, the company you hold those shares in paid you a USD 500 dividend at the end of the second quarter. Meanwhile, you paid your broker USD 150 in fees to purchase the shares on your behalf.
- In this case, the RoR would equal the net price increase of the shares + dividends - brokerage fees ÷ the initial purchase price of the shares.
- The first step would be to break this down to obtain the net profit from your investment. So, this would be USD 14,000 - USD 10,000 + USD 500 - USD 150 = USD 4,350.
- Now, we can use this net profit figure to get the RoR percentage, simply by dividing it by the initial cost of your investment in those shares, as such:
- RoR = USD 4,350 / USD 10,000 = 0.435 x 100 = 43.5%. This final figure is the percentage that your investment has grown by, or your total return on investment.
Using the exact same approach, you can calculate the real return on investment when taking into account factors such as inflation, taxes, fees, and more. It is always important to have an accurate picture of how your portfolio is performing, which is why any reliable RoR calculation should take into account every single cost and cash flow that has been produced by an investment.
How do you calculate the Rate of Return for different assets?
Different assets yield profits and incur losses in different ways. Therefore, it is worth keeping in mind the inputs you will need to calculate the real rate of return on different types of assets. Let's look at some prominent examples.
Stocks
We have already seen how RoR calculations on stocks must include inputs such as dividends and brokerage fees, as well as the overall price change over a given period of time. All of these costs must be accounted for during the entire holding period so that you know exactly how an asset has performed between your initial investment and the moment you decide to cash out and sell the stocks.
Bonds
Calculating the rate of return on bonds is slightly different since bonds pay out an annual interest income, not too dissimilar to how dividends work with shares.
Let's say that you bought USD 500 worth of coupon bonds at 5% interest income. This means that, over the course of a year, your bond coupon paid out USD 25 in interest income.
Now let's say you decide to sell the bond for USD 600 in premium value. So, your profit on the bond is the USD 100 gain from the sale, plus the USD 25 earned in interest. Since your full profit on the bonds is USD 125, we can run an RoR calculation to determine that you have realised a 25% return on investment.
Real estate
Things are more complicated with real estate since there are so many costs associated with owning property, including maintenance, various taxes, and any utilities that you might be liable for. If you are buying a home that you plan to sell in the future, and won't be collecting rental income on that property, then you would need to calculate the initial cost of the house and get a current valuation for the home.
Before you run an RoR calculation, it would be necessary to subtract all costs that have gone into the maintenance of the home over the years, plus any taxes and fees. If you did derive rental income from the property, you can include the total amount collected over the years into your calculation, in the same way, that you would include the dividends from stocks.
What are the advantages of using the Rate of Return calculations?
- Quick to calculate
- Can be used to compare returns and costs of various assets
- Can be used to calculate other performance metrics, such as management cost
- Useful for accounting purposes
What are the disadvantages of using the rate of return calculations?
- Difficult to define profits and costs (i.e. some people do not calculate tax in RoR)
- Different brokers and companies will use different methods of RoR, making comparison tricky
- ROR is not the only measure of the value of an asset (i.e. stability, ethical considerations, etc.)
How can you use RoR to build your portfolio today?
Knowing how to calculate RoR is a valuable skill that can allow you to effectively manage your portfolio over time. At Saxo, you can choose from thousands of assets to build a portfolio that works for you.