Rate of return

A rate of return puts every investment on the same scale. A $10,000 fund that ends the year worth $10,600 and paid $200 in dividends returned 8%, and so did a $50,000 rental that cleared $4,000 and held its value, and the two can be compared without looking at their sizes. The figure counts the income an investment paid as well as the change in its price, and it leaves out the money you added, which is the part people most often get wrong when they read a balance. Over more than a year it is quoted per year, so that three years of one investment and ten of another can be compared too.

In a sentence

• "The fund's rate of return was 8% last year, 6% from the price and 2% from dividends."
• "A savings account's APY is promised in advance. A rate of return is only known afterward."
• "Her balance rose 26%, but the rate of return was 5%. The rest was money she added."

How it's calculated

Rate of return = (end value − start value + income received) ÷ start value

1. Take the value at the start of the period and the value at the end.
2. Add the income paid out along the way: dividends, interest or rent. Income that was reinvested is already in the end value, and counting it again doubles it.
3. Remove what you added and put back what you withdrew. A balance that started at $10,000, took a $2,000 deposit on the first day and ended at $12,600 did not return 26%; $12,000 was invested and it grew by $600, a return of 5%.
4. Annualize a period longer than a year, so that returns over different lengths of time can be compared.

Annualized return = (end value ÷ start value)^(1 ÷ years) − 1

The same investment has several returns, and the name says which.

An example

In its first year, $10,000 in a stock fund ends at $10,600 and pays $200 in dividends. The total return is ($10,600 − $10,000 + $200) ÷ $10,000, or 8%; the price return alone is 6%. With inflation at 3% that year, the example's assumption, the real return is 1.08 ÷ 1.03 − 1, or 4.85%.

Now a different $10,000, in a fund whose price moves in a sequence and pays no dividends, to keep the arithmetic short.

The average of the three yearly returns is 6%, but $10,000 growing at 6% a year for three years would be $11,910, not $11,664. The annualized return is 5.26%, lower than the average because the −10% year had to be recovered from a smaller base, and the annualized figure is the one that says what the money did.

Why it matters

The rate of return is how an investment is judged and how a plan is projected, and both go wrong when the wrong return is used. A fund compared against its index on price return looks worse than it is; a fund advertising its average return looks better than it was; a balance read as a return credits your own deposits to the market. In a retirement projection the return is the assumption everything else compounds on, and a figure a point too high produces a plan that runs out, which is why the honest figure is the real, annualized, after-fee return rather than the largest number on the statement.

Rate of return versus APY

An APY is a rate a bank promises in advance on a deposit, and it cannot be negative; a rate of return is measured afterward on an investment whose value moved, and it can be. The two meet only in hindsight: a savings account paying 4.00% APY delivered a 4.00% rate of return, while a stock fund's return for the same year was whatever the year produced. A second distinction runs through both: the nominal return is the figure as computed, and the real return takes inflation out of it, so an 8% nominal return in a 3% inflation year was worth 4.85% in purchasing power.

Common questions

Is a rate of return the same as interest? No. Interest is one kind of return, set in advance and paid on a deposit or a loan. A rate of return also counts changes in price, and it can be negative, which interest on a deposit never is.

What is a good rate of return? It depends on the risk taken and on inflation. A savings account earns its stated APY with no chance of loss; a diversified stock portfolio has earned more over long stretches of history, with wide swings and losing years along the way, and nothing about the past is a promise. Judge a return against the risk and against inflation rather than against a single number.

Do I count money I added as part of the return? No. Deposits raise the balance without the investment doing anything. Subtract every deposit and add back every withdrawal before dividing, or the figure measures your saving rather than the investment.

What is an annualized return? The one per-year rate that, compounded over the period, produces the total. A fund that turned $10,000 into $11,664 over three years had an annualized return of 5.26%, whatever the individual years looked like.

Is a 10% average return the same as 10% a year? No. An average of yearly returns ignores that a loss must be recovered from a smaller balance, so the compounded result is always lower when the years vary, and the gap grows with the size of the swings.

Go deeper

• The Compound interest calculator shows how a starting balance and a monthly contribution grow at a given return over the years, and how much of the final amount is interest on interest rather than money you put in.
• The Retirement calculator projects what your retirement savings could grow to by the age you plan to stop working and what that is worth in today's dollars, and its common questions cover what return to use.
• How to track net worth when your investments swing every day splits each month's change into what you contributed and what the market moved, which is the return, read monthly.