A rate of return is how much someone gains or loses on a particular investment over time as a fraction of an initial investment. The expected rate of return is how much you predict you will gain or lose, which can be different from your actual rate of return. Investors sometimes discuss required rates of return, which are the minimum expected rates of return to make an investment worthwhile.
The expected rate of return is the amount you expect to lose or gain on an investment over a time period, and this lacks certainty due to market changes, interest rates and other factors. In contrast, the rate of return is how much you actually end up gaining or losing on that investment.
Calculating the Rate of Return
To figure out your rate of return on an investment, subtract the initial amount you invested from the total value of the investment after a period of time. Include in that total value the value of any securities you own, such as stocks or bonds, as well as any dividends or interest you received during the investment. That difference is your return. Divide it by the initial investment to compute the rate of return and then multiply that number by 100 to express the rate as a percentage.
Rates of return are an easy way to compare different investments even if they involved different dollar amounts. For example, if you invested $10,000 in the stock market and ended up with $15,000, and invested $100,000 in bonds and ended up with $110,000, the rates of return are 50 percent and 10 percent. That makes the stock investment arguably the better investment, even though you earned more actual dollars from the bonds.
Expected Rates of Return
Investors can't know with certainty the rates of return they'll get on particular investments. While they might expect a stock to go up in price and pay a dividend, the company could see unexpected market changes that send it struggling. Even seemingly surefire investments such as bonds from top-rated companies occasionally can default if the economy takes a turn for the worse.
To still compare investments and decide where to place their money, investors then will calculate an expected rate of return for an investment based on factors they know, such as overall market conditions, interest rates and facts about the particular investment itself. For instance, a year's investment in a startup company might have an expected rate of return of 10 percent, while an investment in a blue-chip company might have an expected rate of return of 5 percent. Using those expected rates and other information such as relative risk and liquidity of investments, investors can make decisions about where to put their money.
Required Rate of Return
Investors sometimes speak of a required rate of return, which is the minimum expected rate of return for a particular investment decision to make sense. This can be based upon the relative rate of return of other, safer investments. For instance, a stock buy with an expected rate of return of only 1 percent usually makes little sense, since it's possible to get a better rate of return with less risk by putting the money in the bank. An investor might decide that, given a particular investment's riskiness and other factors, a minimum required rate of return is 5 percent, 10 percent or something higher.
- Morningstar.com: Investing Classroom – Course 506 – Calculating Your Personal Rate of Return
- NYU: The Capital Asset Pricing Model (CAPM)
- Investopedia: Expected And Unexpected Returns
- Investopedia: Actual Return
- Investopedia: Required Rate of Return
- Investopedia: Rate of Return
- Corporate Financial Institute: Expected Return