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Negative rate of return is a financial term that refers to a business that has failed to make a profit in a specific time period, where costs have exceeded income. It can also refer to a loss of value in capital investments such as stocks and commodities or real estate. While a return on investment for a new business is often negative in the first few years of operation as the business establishes itself, a negative rate of return does not necessarily indicate a failed business as it is a loss on paper only, until a business is shut down or assets are liquidated. In the stock market, a situation of this type is common with most investments at certain time periods, as the market tends to fluctuate up and down due to circumstances beyond a publicly-traded business or industry's ultimate control over the valuation of their stock.
Another way of referring to negative rate of return in the finance sector is negative return on equity. Equity is an estimate of the monetary value of an asset after all debts owed against it are subtracted, such as the net value of a home after the balance of the mortgage is subtracted. A negative return on equity is often a more accurate way of valuing business assets because it represents the true monetary value that would be obtained if the business were liquidated.
Investments typically have a rate of return that fluctuates as a business goes through various cycles of growth. When a start-up venture is launched, often the cost of capital expenses for land, new equipment, and operational expenses exceeds any potential profit that the business can make in the short-term. This results in a negative rate of return that is expected by investors, with the intention that, given time, the business will make enough profit to pay off initial debts. An example would be a business that invests $1,000,000 US Dollars (USD) in start-up capital and loses $100,000 USD in its first year through operational expenses such as payroll. This represents a negative rate of return of 10%, which can be typical and overcome in succeeding years as the business continues to grow.
While a negative rate of return in a business venture that is ongoing for many years poses the risk of a complete loss of the initial capital investment if the company does not recover, similar rate of return (ROR) risks exist in the stock market. Diversification in stock investing is a fundamental method of avoiding an overall negative rate of return, as it is nearly impossible to avoid the fact that some stock holdings in a portfolio will have declining values at any given time. Mutual funds and index funds attempt to avoid this risk by being investments that span across a wide range of industries and business sectors.
Another important aspect to consider with return on investment (ROI) calculations is a negative real rate of return or real rate of return if it is positive. A real rate of return adds inflation into the calculations for the growth or decline in value of an asset. If a stock value, for instance, has gone up 5% in the past year, but the rate of inflation for products in that sector of the economy has increased by 6%, then the stock can be said to have a negative real rate of return of 1% if it were to be sold. Calculating the rate of return without taking inflationary changes into account is referred to as a nominal rate of return. Other measures in capital markets can also affect a basic rate of return for a business or in valuing an asset, such as dividend reinvestments that increase stock value over time or changes in interest rates that affect the cost of borrowing to acquire new capital.