When you lend someone money, you typically expect to receive the same amount in return -- and perhaps something more. This is the case when a bank extends credit to a person or a company, or when an investor buys a stock or bond. Banks and investors expect to be compensated for granting access to their money. That compensation—usually a percentage on top of the principal amount loaned or invested—is known as the rate of return.
What is Rate of Return?
Simply put, the Rate of Return (often abbreviated as ROR) is the gain or loss for any investment, in percentage terms, for a given period of time. The period can vary—a month, a year, a quarter—but the standard for comparing returns is a one-year time frame.
The formula is simple:
(Price received at end of investment – Price paid at beginning of investment) / Price paid at the beginning
Rate of return can be used for any investment, including stocks, bonds, real estate, art and antiques—and now, even cryptocurrencies. Because rate of return is expressed as a percentage, it makes it possible to compare returns on different assets, no matter how many dollars are at stake.
How to calculate rate of return
For example, let’s say you bought a share of Netflix in March 2020 for $350 a share. A year later you sell the share for $500. Your gain is $500 – $350 = $150, and your rate of return is:
$150/$350 = 0.4285 or 42.85%
Now suppose you sold your house for $500,000 a year after buying it for $400,000. Your gain is $100,000 and your rate of return is:
$100,000/$400,00 = 0.25 or 25%
Despite the huge difference in size, the Netflix investment gave you more bang for the invested buck.
To calculate rate of return in an Excel spreadsheet, you can easily enter a formula:
- Enter current value of the investment in one row.
- Enter original value (cost) of investment in row below current value.
- In a row above these two, enter the formula for rate of return:
(Current value – Original value)/original value
- Current value: Cell B6
- Original value: Cell B7
- Rate of Return: Cell B5, enter: =(B6-B7)/100*B7
Side note: Try Titan’s free Investment Calculator to project your potential investment returns over a period of time.
Using rate of return to compare investments
Rates of return can be used to compare different types of investments, like stocks and real estate in the above example, or similar investments, such as shares of Walt Disney Co. and Amazon Inc., which compete with Netflix in film and entertainment production and distribution.
Besides changes in market price, rates of return are influenced by income received. Income is the primary driver for bonds (interest paid) and commercial real estate (rent). For most stocks, dividend income makes a smaller contribution. Price changes and income received are added to calculate an investment’s total return.
We will focus here on stocks and bonds.
Rate of return on stocks and dividends
Stocks produce income from dividends, or that portion of earnings that a company's board decides to pay to shareholders.
More than 400 of the S&P 500 index companies pay a dividend. But some of the biggest companies, including Amazon, Netflix and Alphabet (parent of Google), don’t. The decision to pay a dividend is up to the directors, who are elected to represent the shareholders.
Here is the total return formula for dividend-paying stocks:
Price change for investment (gain or loss) + dividends/Price at beginning of investment
And here is an example using a hypothetical company:
You bought a share of Kerfuffle Corp. more than a year ago for $60. Now you’re selling it at the market price of $75, for a $15 gain. The company pays a quarterly dividend of $1.25 a share, and you received four quarterly payments for a total $5 of dividends. Your total return is:
$15 + $5/$60 = 0.33 or 33.3%
Dividends can make a difference in an investor’s rate of return. Almost 100 of the 500 companies in the S&P 500 index have dividend yields (annual dividend payment divided by current stock price) of more than 3%, as of the first quarter of 2021.
A good example of the dividend boost is Kraft Heinz Co., which makes brand-name processed foods. Its stock price had risen about 6.2% in 2021 as of early August. Its dividend yield was 4.1% (the yield fluctuates as the stock price changes). Combine them for Kraft Heinz’s one-year total return, August-to-August:
6.2% + 4.1% = 10.3%
Those extra percentage points, compounded over time, make a big difference in how much wealth an investor accumulates.
Keep in mind that generous dividend-paying companies are often in slowing industries with limited growth prospects. Their shares don’t typically rise as much as faster-growing companies such as Amazon, Alphabet and Netflix (which don’t pay dividends) often do.
Rate of return on bonds and interest
A bond is backed by a contract, which specifies how much interest a company, a government, or an agency will pay the bond investor, and when (quarterly, annually, semi-annually).
Let’s stick with Kerfuffle for a bond example. A year ago the company decided to raise $100 million by selling bonds, and used the proceeds to expand its business. It agreed to pay a 5% annual interest rate. You bought one of the bonds a year ago for $1,000 (bonds are typically sold in denominations of $1,000, called face value). You will receive 5% interest on the $1,000, or $50.
A year later, you are able to sell the bond for $1,020, because interest rates have been declining (making your 5% bond look relatively attractive). You gained $20 from selling the bond, and you received $50 interest. Your total return:
$50 + $20/$1,000 = 0.07 or 7%
What’s a good rate of return?
So, what is a good rate of return? A better question would be: what is an appropriate rate of return? That depends on an investor’s goals, time horizon, and willingness to tolerate risk and ride out price swings.
Investors with a low tolerance for risk and price volatility, and who want steady income, tend to hold more bonds or exchange-traded funds that invest in a variety of bonds. On the other hand, those with a greater appetite for risk and volatility—and the potentially higher returns—might keep more money in stocks or stock-focused ETFs.
The process of mixing investment types and balancing their expected rates of return against their risks is called asset allocation. This leads most investors to hold a mix of investments that will produce a blended or weighted average rate of return.
Imagine an investment portfolio made up of half stocks, generating a return of 20% a year, and half bonds, with a return of 6%. The calculation for the weighted return for this portfolio would look like this:
Just for the sake of comparison, a mix of 75% stocks and 25% would have a weighted return of 16.5%, using the above formula. Conversely, a portfolio of 75% bonds and 25% stocks would produce a 9.5% return.
Limitations of rate of return calculations
The most critical issue that limits rate of return calculations is inflation, because it erodes the value of money and eats into returns. Investors must subtract the current or expected inflation rate from the so-called nominal rate of return (in the above case, 13%) to show an inflation-adjusted, or real rate of return.
In the example above, let’s assume inflation is 3% and is expected by economists to stay at that rate for several years. The real rate of return for the half-stocks, half-bonds portfolio is:
13% - 3% = 10%
Investors should keep this in mind because the faster inflation accelerates, the more it could threaten their returns.