RATES OF RETURN : UNDERSTAND, MEASURE AND COMPARE What do rates of returns historical rates of return on investments and why are they important? This is the metric most used to compare different investments.
It is expressed as a percent because investment opportunities come in all sizes. The profits from an investment can come from income received during the holding period, and also capital gains from the eventual sale. Together these are called the “total return”. When comparing investments always use the total return. Detailed instructions for measuring your own portfolio’s rate of return are on the page Keep Track. Are quoted rates of return comparable between investments?
Each of the asset types in the box below has its returns normally calculated in a different way. For most uses the results are ‘good enough’ for comparison. But for any fine-tuning of a decision take the time to translate the ‘normally’ calculated return into a ‘true’ economic rate of return. The ‘true’ economic rate of return is what most people’s understanding of it would be. Essentially these all refer to the same concept. Different terms are used in different contexts.
The period used is one year. Any income paid early is re-invested to earn its own income for the remaining portion of the year, or considered to have done so. That income-on-income is included in the end-of-year value. There are many different words used to describe the measurement convention used in different situations. Unfortunately people use different words for the same thing, and use the same word to mean different thing. Always clarify in your mind what is being meant, without preconceptions. NOMINAL returns: Real rates of return are what is left after the rate of inflation has been subtracted from the nominal rate.
Much analysis of historical stock returns uses real returns because all investors demand at least the rate of inflation in order to justify deferring consumption, so it is premium above inflation that matters. GDP is the yearly production of a country measured using the market value of items. Its year-to-year change is heavily influenced by the inflation increases of the transactions. This is the technically correct math but the simple subtraction is good enough.