Rate of Return Puts Gains and Losses on the Same Scale

Your brother-in-law cleared $5,000 on one trade and hasn't stopped talking about it. He leaves out the $250,000 he had riding on it — a 2% rate of return.

Rate of return expresses a gain or loss as a percentage of what you started with, over a stated period. That percentage is what lets a $500 position and a $500,000 portfolio share one scale.

How the math works

The basic formula: ending value minus starting value, plus any income, divided by the starting value. Multiply by 100 and you have the rate.

Say $8,000 grows to $8,600 and pays $200 in dividends along the way. That's $800 of total gain on $8,000 — a 10% rate of return.

Compare it with $1,000 earned on a $20,000 balance. The dollar gain is bigger, but the 5% rate is half as good.

The period is part of the number

Ten percent over one year and 10% over five years are entirely different results. Annualized, the five-year version works out to about 1.9% per year, because compounding bends the math below the naive 2%.

Be careful annualizing short streaks, though. A 5% gain in six months doesn't guarantee the second half will repeat it.

Price isn't the whole story

Dividends and interest belong in the calculation, which is why total return beats price-only charts. In flat years, an investment's yield can carry the entire result.

Deposits and withdrawals muddy the water further. Add $5,000 the day before a rally, and a naive start-to-finish calculation credits skill for money that was barely in the market.

Past rates, future guesses

A historical rate of return describes one path that already happened, often with brutal volatility hidden inside the smooth average. It can inform expectations, but it can't sign guarantees.

The SEC's investing overview covers the fundamentals from the regulator's side.

Next time someone quotes a gain in dollars, ask for the starting balance and the dates before you're impressed.