All investors hope to make money on their investment, expressed as a "gain." But you don't have to be a big player in the stock market to be an investor. Although you may not think of yourself as an investor, you have an investment if you own your home. By calculating the rate of return with a simple math formula, you can evaluate how well your investment is performing.
What Is Rate of Return?
The rate of return definition (ROR), also called return on investment (ROI), is the percentage of net gain or net loss that you realize on an investment during a certain time period when compared to your initial investment cost. A rate of return can be positive or negative, depending on whether you profit from your investment (positive ROR) or experience a loss on the investment (negative ROR).
Rate of Return Utility
Perhaps the most basic use for calculating ROR is to determine whether an individual or a company is making a profit or loss on an investment. Other than analyzing personal investment growth, ROR in the business sector can shed a light on how a company's investments are performing when compared to industry norms and competitors.
Rate of Return Formula
Putting pen to paper, the formula for calculating a simple rate of return is:
Rate of Return = [(Current value of investment) minus (Initial value of investment)] divided by (Initial value of investment) times 100
If you're keeping your investment, the current value simply represents what it's worth right now. But the current value of an investment may also represent its ending value; for example, if you're selling your house.
Sample ROR Calculation
You can calculate ROR for any type of investment or asset, including securities, such as stock, or real estate.
If you want to calculate the ROR of your home that you bought for $200,000, we'll assume (for example's sake) that you paid 100 percent cash for the home. When you decide to sell your home, you'll net $280,000, after deducting all costs and fees for selling it. Your ROR in this example is 40 percent ($280,000 minus $200,000 divided by $200,000 times 100).
If, however, you sell your home at a loss, you'll see a negative ROR. Let's say you sell it for $180,000, after paying $200,000 for it. Your ROR in this example is -10 percent.
Downside to Simple ROR
If there were no economic inflation to consider, calculating simple ROR would be an accurate barometer of gain or loss. But inflation is a very real consideration in real-life metrics, because it reduces the purchasing power of money. And unlike simple (or nominal) ROR, which doesn't factor in an inflation variable, a "real" rate of return does.
Also called an inflation-adjusted ROR, the real rate of return makes adjustments for inflation to yield a more accurate measure of your actual gain or loss on investments. This calculation is more accurate because a house, for example, that's worth $200,000 today does not represent the same value that it had 10 years ago.
Real ROR Calculation
By subtracting the inflation rate from the simple/nominal ROR, you'll calculate the real ROR, expressed as the equation:
Real rate of return = Simple/nominal interest rate – Inflation rate
For example, if you have an investment that pays 5 percent interest per year, but the inflation rate is 3 percent, your real rate of return on the investment is 2 percent (5 percent nominal interest rate minus 2 percent inflation rate).