Rate of Return

Rate of Return (often called return on investment (ROI)) is the ultimate scorecard for any investment. In simple terms, it's the net profit or loss you make on an investment over a certain period, expressed as a percentage of your initial investment. Think of it as the answer to the most fundamental question: “How much money did my money make?” Whether you're buying a single share of stock, a rental property, or a government bond, the rate of return tells you how effectively your capital has been working for you. For a value investor, understanding the rate of return is not just about chasing high numbers; it's about evaluating whether the potential return is worth the risk involved. It’s a crucial metric for comparing different investment opportunities and for measuring your progress toward your financial goals. A solid grasp of this concept is your first step from being a mere saver to becoming a savvy investor.

The basic formula is straightforward and easy to remember. (Current Value - Initial Value) / Initial Value x 100% = Rate of Return Let's use a simple example. Imagine you buy one share of 'Cappuccino Corp.' for €100. A year later, the share price has risen to €115. (€115 - €100) / €100 x 100% = 15% Your rate of return for that year is 15%. This 15% is your capital gain. But what if Cappuccino Corp. also paid you a €5 dividend during that year? This is where things get more interesting.

A true investor knows that the price change is only part of the story. The Total Return includes all profits from an investment, including both capital gains and any income received, like dividends or interest. Using our Cappuccino Corp. example:

• Initial Investment: €100
• Ending Value: €115
• Income Received (Dividend): €5
• Total Profit: (€115 - €100) + €5 = €20

Now, let's calculate the total return: (€20 / €100) x 100% = 20% By including the dividend, your return looks much better! This is why value investors love dividend-paying stocks—they get paid to wait for the stock's value to appreciate.

Not all returns are calculated over a neat one-year period. To make fair comparisons, we need a few more tools in our belt.

The Holding Period Return (HPR) is simply the total return you get during the specific time you own an asset, whether it's six months, three years, or ten days. The 20% we calculated for Cappuccino Corp. is its HPR for the one-year period we held it. It's a useful measure, but it makes it hard to compare an investment held for 9 months with one held for 5 years. That's where annualizing comes in.

The annualized rate of return converts your HPR into a yearly figure. This is incredibly important because it allows you to compare investments on an “apples-to-apples” basis, regardless of how long you held them. For example, a 10% return over six months is much better than a 10% return over two years. The annualized return for the first investment would be approximately 21%, while for the second it's only about 4.9%. This standardization helps you make much smarter decisions.

A high rate of return is fantastic, but it's meaningless without considering the risk taken to achieve it. A 50% return from a speculative startup is very different from a 10% return from a stable blue-chip company. Value investors, following the wisdom of figures like Benjamin Graham and Warren Buffett, are obsessed with risk-adjusted return. Their goal is not to get the highest possible return, but to get the best possible return for the lowest possible risk. Always ask: “Is this potential reward worth the potential sleepless nights?”

This might be the most crucial lesson of all. The number you see on your statement—like our 20% return—is the Nominal Return. But what truly matters is your Real Rate of Return, which is your nominal return minus the rate of inflation. Imagine you earned that 20% return, but inflation for that year was 3%. Real Rate of Return ≈ Nominal Return - Inflation Rate 20% - 3% = 17% Your Real Rate of Return is 17%. This means your actual purchasing power—your ability to buy goods and services—only increased by 17%, not 20%. Inflation is a silent thief that erodes your profits over time. A value investor always keeps one eye on returns and the other on inflation, ensuring their wealth is growing in real terms. As Warren Buffett famously said, the first rule of investing is to not lose money, and the second rule is to not forget the first rule. Inflation is one of the easiest ways to lose money without even noticing.