Time is money, or so the saying goes. Money isn't spent in a capitalist society without someone looking for something in return, and the amount of time it will take to generate profits is crucial to measuring the value of a potential investment. Even qualified charitable contributions have some return, since they can be used to lower a contributor's taxable income. Thus, the rate of return is one of the most important metrics for those with capital to invest.
Smart investors weigh the risk of an investment against the potential return. If the reward justifies the risk, it may be deemed favorable. The rate of return is essential in comparing the profitability of one investment versus another. Once an investment is entered into, rate of return is used to evaluate the performance of an investment, which does not always conform to initial estimates.
In all cases, rate of return requires a fixed initial cost of the investment and a current or final value, even if these figures must be estimated. The rate of return then becomes the difference between the initial investment and its current or final value, divided by the initial investment. This ratio, which shows the percent by which an investment has appreciated or depreciated, can unfortunately be negative in value. The rate of return is sometimes also called the arithmetic return, return on investment, or, when compounded, the yield.
Not surprisingly, financial analysts have devised several different methods for calculating rate of return. A particularly practical method devises the real rate of return by factoring the effects of inflation on returns by either adjusting the final value of an investment or subtracting the rate of inflation from the nominal rate of return. A very popular method of figuring returns is to average the change in value of a multi-year investment into an annualized rate. But this shouldn't be confused with an annual rate of return, which is the actual rate of return for a given year.
No savvy investor puts money on the line without at least some idea of the potential return, whether it's mutual funds or real estate. When evaluating individual companies, investors use a rate of return measure called return on investment, or ROI, to evaluate how much capital a company generates over a given period (usually a quarter) for each dollar it invests in business operations. The details of the calculation will depend on the business model of the company, but for a value investor, a positive and steady ROI will be essential, whereas a growth-oriented investor will look to the first and second derivatives of ROI to find not only growth, but accelerating growth.
For most asset classes as a whole, potential rate of return is balanced by risk, that is, the potential for an equally negative rate of return. A classic example would be the yield on U.S. Treasuries versus junk bonds. Treasuries pay relatively little for virtually guaranteed returns whereas lower rated debt must pay more to compensate for the possibility of significant loss through default. An opportunistic investor is able identify those moments when, for whatever reason, the likelihood of loss is dwarfed by the potential for gain. An annualized rate of return might not reflect this opportunity in a volatile market, but the actual rate of return as reflected in the investors profit and loss statement likely would.