What is the Rate of Return?
A rate of return is measure of profit as a percentage of investment.
How Does the Rate of Return Work?
Let's say John Doe opens a lemonade stand. He invests $500 in the venture, and the lemonade stand makes about $10 a day, or about $3,000 a year (he takes some days off).
In its simplest form, John Doe's rate of return in one year is simply the profits as a percentage of the investment, or $3,000/$500 = 600%.
There is one fundamental relationship you should be aware of when thinking about rates of return: the riskier the venture, the higher the expected rate of return.
For example, investing in a restaurant is much riskier than investing in Treasury bills. One is backed by the full faith and credit of the United States government; the other is backed by your cousin's sofa. Accordingly, the risk that you'll lose your money is much higher in the restaurant scenario, and to induce and reward you to make the investment, the anticipated returns have to be much higher than the 1% that the Treasury bill would pay. Inversely, the safer the investment, the lower the expected rate of return should be.
Why Does the Rate of Return Matter?
If only it were that simple. Rates of return often involve incorporating other factors, including the bites that inflation and taxes take out of profits, the length of time involved, and any additional capital an investor makes in the venture. If the investment is foreign, then changes in exchange rates will also affect the rate of return.
Compounded annual growth rate (CAGR) is a common rate of return measure that represents the annual growth rate of an investment for a specific period of time.
The formula for CAGR is:
CAGR = (EV/BV)1/n - 1
EV = The investment's ending value
BV = The investment's beginning value
n = Years
For example, let's assume you invest $1,000 in the Company XYZ mutual fund, and over the next five years, the portfolio looks like this:
End of Year Ending Value
Using this information and the formula above, we can calculate that the CAGR for the investment is:
CAGR = ($5,000/$1,000)1/5 - 1 = .37972 = 37.97%