Understanding Rates of Return
Jarrett McKay - Mar 20, 2017
The rate of return calculation is one of the best metrics for comparing the performance of investments. In its basic form, the rate of return is simply the change in the value of an investment, generally net of fees, divided by the original amount of
The rate of return calculation is one of the best metrics for comparing the performance of investments. In its basic form, the rate of return is simply the change in the value of an investment, generally net of fees, divided by the original amount of the investment expressed as a percentage.
Rates of return are usually calculated over a one year period to generate an annual rate of return. Over longer time periods, the rate of return is calculated as an annualized figure. This is often seen with mutual funds which may quote performance for one, three, five and ten-year time periods. The annualized figure provides an estimated annual return and can be used to compare the performance of investments over different time periods.
Don’t Forget Volatility
Annualized returns don’t necessarily tell the whole story. Two investments that have the same annualized rate of return can have completely different return profiles. An annualized rate can disguise volatility that may have occurred over a specific period.
As an example, a less volatile investment that provides a steady return of 5 percent each year for three years will have an annualized return of 5 percent. Another more volatile investment may have annual returns of 1, -10, and 24 percent over the same time period but will have the same annualized return of 5 percent.
Investors should be careful to not only consider annualized returns when comparing investments. In many cases, an investment yielding reasonable annualized returns with lower volatility will be preferred over one with higher volatility.
Calculating Your Rate of Return
When determining your rate of return on an investment or portfolio, keep in mind that the calculation may become more complicated if you need to consider any contributions or withdrawals that occur during the period of time for which you are calculating your return.
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