What Is the Difference Between the Rate of Return & the Realized Rate of Return?
- Investors often use the terms "rate of return" and "return on investment" interchangeably. Calculating the rate of return is a simple way for investors to determine how much money their investments have earned since the time of purchase. The most simple equation for calculating the rate of return is initial investment amount plus gains made from the investment minus costs, divided by the cost of the investment at the time of purchase. Investors also calculate the rate of return to determine how long it will take the investment to earn back, or return, the initial principal investment amount.
- Consider an example in which you paid $10,000 for an investment that returned $1,000 in its first year. At the end of the year, your total investment value is $11,000. Your rate of return is: $11,000 - $10,000 / $10,000 or 10 percent. At this rate of return, it would take your investment 10 years to earn back your initial investment of $10,000 ($10,000 / $1,000 = 10 years). If the same $10,000 investment returned $800 per year, your rate of return is $10,800 - $10,000 / $10,000 = 8 percent. In this case, it would take your investment 12 years and six months to earn back your initial investment ($10,000 / $800 = 12.5 years).
- The realized rate of return employs the same financial concepts of the rate of return, and makes an adjustment for the dollar-depreciating nature of inflation. Consider the same $10,000 investment that earns $1,000 in the first year for a 10 percent rate of return. Factor an inflation rate of 3 percent. Your real rate of return is 7 percent. With a real rate of return of 7 percent, your yearly gain is $700. In this case, it would take approximately 14 years and four months to earn back your initial principal investment of $10,000.
- To adjust for losses when calculating the rate of return and realized rate of return, subtract the investment's losses from its gains. In the example of the $10,000 investment, at the end of year one, your realized rate of return is 7 percent. If you were to cash out your investment at the end of year one, you would pocket an additional $700 on top of your $10,000 initial investment. At the beginning of year two, your investment is worth $10,700. At the end of year two, your investment incurs losses of $500 and its value has dropped to $10,200. Your realized rate of return drops to 2 percent.