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The rate of return is the amount of money a person earns relative to the amount of money he invests. It is used to track all different types of investments, from investments in a savings account to profits and losses earned on investments in stocks. The return can be equal to interest income, the profit or loss an investor incurs from an investment, or a person's net gain or loss.
The initial amount of money a person invests is usually referred to as the principal, although it can also be called the cost basis or the investment capital. The rate of return is compared to the amount of money the person initially invests. These two numbers are compared in order to give an accurate picture of how well the investment paid off.
This type of measurement is necessary to calculate the actual performance of investments when differing amounts of money are invested. For example, an investment of $100 on which a person earns $50 would be an excellent investment, with a fifty-percent rate of return. If the initial investment was $10,000 and earned $50, on the other hand, the investment would have a rate of return of only five percent.
Calculating the rate the investment returns is essential to making investment decisions. Riskier investments must have a higher projected rate in order to be worthwhile. An investment with a relatively low projected rate of return, on the other hand, generally should be low risk in order to still be worthwhile.
For example, a savings account might have a relatively low projected rate that it will return. Because the investment is safe, however, a lower rate is acceptable. Stocks typically should have a higher projected rate the money will return, since the investor takes more risk in this situation.
The rate of return can be calculated in two ways: average rate or compound rate. The average rate is best used to measure how investments perform in the short term. It is calculated by figuring the mean return over the period of time in question, and dividing by the number of years in question.
The compound rate, on the other hand, is better used to calculate the return on an investment over a longer period of time. It is calculated by dividing the geometric mean by the number of years in question. To determine the geometric mean, the returns in question are multiplied, and the square root is taken.
@Charred - Stocks are generally good investments, but both of the examples mentioned in the article – that for an expected rate of return for fifty percent in one instance or five percent in another instance – are way off the mark from what people actually experience.
I think that the lure of a high rate of return is what propelled a lot of young, novice investors into the Internet bubble of the late 1990s. People were doubling and tripling their money with ease, thinking that this was the norm for stocks, when it was anything but normal.
Experienced investors who understood that the phenomenon was not normal should have cashed in their chips early (some of them did) and avoided the meltdown. Most of the naive plodded ahead, and suffered for it; count me in the latter group.
@Mammmood - Even with stocks, there are other things that affect the rate of return.
For example, I do dollar cost averaging for my stock market investments, and this throws a monkey wrench in my rate of return calculation. In dollar cost averaging, you put a certain amount of money in the stock market every month.
Since you may be buying the same stock at various price points, it’s not that straightforward to figure out what the rate of return is on your final price. You may have bought some of the stock when it was $10 a share, some when it was $20 a share, and so forth.
There is actually a formula to figure out what your return is, but looking at the formula gave me headaches and flashbacks of college math. So I bought a stock market program and it figured it out for me.
One thing that affects all investment decisions is the rate of inflation. This is why I never put all my money in the bank. Yes, it’s safe to do that from a risk perspective, but it’s not safe when you consider how inflation eats away at the real value of your dollars.
You can calculate the real rate of return on an investment to account for the impact of inflation; just take the expected rate of return and subtract the inflation rate, and that’s basically your rate of return.
Obviously even low inflation will make typical bank and CD deposits almost net loss investments over the long haul, so you’re better off putting your money in the stock market in my opinion, where the average rate of return is about seven percent.
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