Rate of return (RoR) is a financial metric that measures the gain or loss on an investment relative to its initial cost. It is expressed as a percentage and helps investors assess the profitability of an investment over a specific period.
The formula for calculating the rate of return is as follows:
Rate of Return = [(Current Value of Investment - Initial Investment) / Initial Investment] x 100
In this formula:
- Current Value of Investment: This refers to the current market value of the investment or asset.
- Initial Investment: This represents the original cost or the amount of money initially invested in the asset.
The rate of return can be positive or negative, depending on whether the investment has gained or lost value. A positive rate of return indicates that the investment has generated a profit, while a negative rate of return signifies a loss.
For example, suppose an individual purchased a stock for $1,000 and the current market value of that stock is $1,200. The rate of return on the investment would be:
RoR = [(1,200 - 1,000) / 1,000] x 100 = 20%
In this case, the rate of return is 20%, indicating a 20% profit on the initial investment.
Rate of return is a crucial metric for investors as it allows them to assess the performance of their investments and compare different investment opportunities. However, it's important to note that the rate of return doesn't consider the time period over which the investment has been held or any intermediate cash flows (such as dividends or interest payments). To get a more accurate picture of investment performance, investors may use other measures like the annualized rate of return or the compound annual growth rate (CAGR).