What does rate of return mean?
Your rate of return measures the gain or loss on your investment over any period. For example, let’s say you bought your house for $250,000 several years ago, and a real estate agent recently told you it’s worth about $325,000. Your return (if you sold it today) is the difference between the two prices—$75,000, but your rate of return is the percent change in the price, calculated as follows.
|Rate of return = (Current price – Original price) ÷ (Original price) x 100|
You’d make a 30% rate of return on your house if you sold it today for $325,000.
Your rate of return doesn’t account for the ups and downs between when you bought the house (or other investment) and when you sold it. It just focuses on how much you paid to buy it and how much you receive when you sell it.
Some investments use a total rate of return
Some investments work the same way as your house—the return you get is the difference between the buying and selling price. Some investments, however, also pay interest or dividends while you own them. When you calculate your rate of return, you’ll want to consider factoring those in by adding them to the current price in the formula above. This is your total rate of return.
|Total rate of return = (Current price + Interest payments – Original price) ÷ (Original price) x 100|
But even that isn’t quite complete, as it doesn’t account for inflation—the decrease in your money’s purchasing power, or value, over time.
Inflation-adjusted rate of return considers the value of money over time
Adding inflation to the equation helps you to measure the change in value of your money when you sell an investment, not just how many dollars you make. An investment can have a positive rate of return (meaning that the sale price is higher than the purchase price) but a negative inflation-adjusted rate of return (meaning that the money from the sale doesn’t buy as much as the money spent to buy the investment).
To calculate your inflation-adjusted return, you subtract the inflation rate from your rate of return.1
|Inflation‐adjusted rate of return = Rate of return – Inflation rate|
Think of it using this example:
- You buy a bag of groceries for $40 and invest another $40 on the same day.
- Ten years later, the same bag of groceries costs you $42.40—a $2.40, or 6%, increase in cost.
- Ten years later, the $40 you invested is now worth $42—a $2 gain, or 5% rate of return.
So, although you made 5% on your investment, you still need an additional $0.40 to buy the same bag of groceries. This is because inflation grew at a faster pace than your investments—your inflation-adjusted rate of return was negative.
Compound annual growth rate
Your compound annual growth rate (CAGR) helps you compare the performances of investments you own for different lengths of time.
For example, you invest $100 in two stocks, Stock A and Stock B. You make a 20% rate of return on Stock A after two years and 40% on Stock B after seven years. Which one performed better? The answer is, it depends.
If you only care about the total return, regardless of how long you hold the stock, then Stock B clearly made you more money (40% vs. 20%). But it took Stock B seven years to make 40%—what if you held Stock A for seven years instead of two years? Would it have made more than 40% with five more years?
Comparing CAGRs enables you to see the average annual return of these investments so you can answer the question, “Which investment earns more each year, on average?”
|CAGR = [(Current price) ÷ (Original price)]^(1 ÷ Years) – 1|
The CAGR of Stock A is 9.5%, and the CAGR of Stock B is 4.9%. That means:
- Stock A averaged a 9.5% return in both years, for a total rate of return of 20%.
- Stock B, on the other hand, only made 4.9% per year, on average.
The CAGR formula helps you standardize performance for easier comparisons.
How to use different return measurements in your retirement planning
Get help achieving your financial goals by knowing when to use different rates of return.
Total rate of return—This helps you know how much you made on an investment overall. It accounts for interest payments or dividends you receive and doesn’t account for how long you own something. It can be simple, quick, and easy to understand and use.
Inflation-adjusted rate of return—It’s important to know how inflation affects the value of your money over a long period. For example, if you started your career in 1982 and determined you needed $40,000 per year in retirement, you may plan your retirement savings strategy around receiving that amount. But $40,000 in buying power in 1982 equals $119,256 in 2022 when you account for inflation2; in other words, you need $119,256 in 2022 to live the same lifestyle $40,000 would have afforded you in 1982. Consider incorporating inflation in your retirement planning to help ensure you’re targeting the right number.
CAGR—This measurement helps you answer the question, "What average annual rate of return do I need to earn for my current savings to help reach my retirement savings goal?" For example, if you inherited a $200,000 individual retirement account (IRA) from your aunt, and you need $2,000,000 to retire in 30 years, you’d need an 8.0% CAGR to achieve your goal. Additional savings you might have may reduce the CAGR you need to reach $2,000,000, but if you can’t save more, you know what annual rate of return you need to earn every year.
Measure your performance to stay on track
There are different ways to measure how much money you make or lose from your investments, so make sure you know when each measurement is appropriate and how to interpret the results. There’s some math involved, but nothing a calculator or Excel spreadsheet can’t help you with. Use these three rates of return to help you set and achieve your financial goals.
All examples are hypothetical mathematical illustrations only. Figures are based on assumptions as set out, and individual circumstances may vary.
1 This formula provides a simplified estimate for inflation-adjusted return. The true formula is [(1 + Total rate of return %) ÷ (1 + Inflation rate %) – 1] x 100. 2 CPI Inflation Calculator, U.S. Bureau of Labor statistics, 2022. Assumptions: $40,000 in January 1982 has the same buying power as $119,256.84 in January 2022.
The content of this document is for general information only and is believed to be accurate and reliable as of the posting date, but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made.