"Did I earn a good rate of return on my investment?" This is a simple enough question, and the process of calculating and interpreting the rate of return from an investment would seem equally simple: determine what amount was invested and what amount was received in return; then, express the return as a percentage.
Unfortunately, calculating and interpreting returns in the investment world are far
from simple. While the factors of time, risk, taxes, investor goals, and the
performance of other investments all contribute to a more complete
understanding of investment returns, they also make the process more complex.
Given a 10% rate of return, one might ask several questions:
By itself, 10% provides no information for answering these important questions. Few numbers by themselves have significance. Most take on meaning only when viewed in relation to something else. How did alternative investments or the overall market perform? How did the investment perform relative to the rate of return the client needs to achieve his or her goals? How did the investment perform in relation to its own past returns? A rate of return is meaningful only in relation to each of these questions. As you will see, different methods of calculating returns have been developed to deal with each of the issues just described. Calculating and interpreting returns correctly requires a level of sophistication that all financial professionals should master. Keep in mind that you do not need a financial function calculator for this course.
Jason G. Hovde is the investments professor at the College for Financial Planning. Prior to joining the College, Jason had a financial planning/investment advisory practice and was a branch manager for one of the largest independent broker/dealers in the country. Additionally, he spent several years with another independent broker/dealer, first as a trader and options principal, and then as a member of the senior management team. Jason holds two bachelor’s degrees, one in accounting and the other in behavioral science from Metropolitan State University of Denver, as well as an MBA in finance and accounting from Regis University. You can contact Jason at firstname.lastname@example.org.