Rate of return

Definition: What your investment is earning you, expressed as a percentage of what you have invested, as follows:

– Amount of money you earn in one year / Amount of money you have invested
– Multiplying the result by 100 to make it into a percentage

Example: Wilbur inherits $500,000. He places the money into various investments. In one year’s time, his investments have earned him $40,000. He may have received checks totaling this amount or chosen to “let it ride”, allowing his investments to grow to $540,000 in value. His rate of return is $40,000 / $500,000 * 100, or 8%.

Investeach explains: The standard period of time over which to measure rate of return is one year. Be careful when you read about how an investment returned 100% over 10 years, meaning that it doubled in that time. You might be tempted to divide 10 into 100% and conclude that this investment earned 10% per year. This is not the case.

First, when judging an investment’s return over a multi-year period, we assume that we’re “letting it ride”, meaning we keep everything we’ve earned invested alongside our original investment. Because of this, after the first year we’ll have earnings on our earnings. This is called compounding. With it, an investment that doubles in 10 years as we described above is actually earning just over 7% per year.

Understand that with the vast majority of investments (such as stocks and bonds) we are able to take the amount of money we invested (plus any we let ride) back when we are no longer satisfied with what it is invested in. We don’t give up our investment for the right to receive some future payments. Of course, if you invest your money in stocks or bonds, they can fall in value, meaning that when you sell them you will get back less than you invested.

Finally, while we are trying to grow our investments, something else may be growing as well, and that is the prices of the things we buy and the services we consume. How rapidly these prices are growing is called the inflation rate. Interestingly, just like rate of return, it is measured over a one-year period and is expressed as a percentage. Having these things in common allows us to compute how fast the real purchasing power of our investments is growing, as follows:

Real rate of return = Rate of return of our investments – Inflation rate.

For example, if your investments earned 7% in the most recent year and the inflation rate was 3% for the year, then the real rate of return is 7% – 3%, or 4%.

Riddle me this:

1. Over what period of time is rate of return measured?
2. What is the rate of return of a $120,000 investment that earns $10,000 per year?
3. What is the benefit of letting an investment’s annual return ride with the original investment?
4. What is a risk of investing money in stocks and bonds in our quest to earn a high rate of return?
5. What do we call the increase in the prices of the things we buy and services we consume?
6. How do we measure how much our investments are growing in real terms?