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.