Investment Definitions: Rate of Return

As we continue our Investment Definitions series, we come to a term that may be thrown about quite casually. But when you're first beginning to learn about investments, even one of the most-used terms can trip you up. For that reason, we'll cover the Rate of Return in detail.

What is the Rate of Return?

In its simplest definition, the Rate of Return (also called the Return on Investment) is the amount of money you receive back on your initial investment. It is usually expressed in a percentage over a specified period of time, and the Rate of Return most often includes the interest, profits and/or net income (profit minus loss).

As we look at the Rate of Return (ROR) more in depth, we can further define it in terms of the type of investment. Since ROR can be used to show how much cash any type of investment returns, from a business investment to a 401(k) to a stock purchase, there are many ways to calculate the ROR. Since this is an introduction, though, we'll leave the mathematical equations to the experts and focus more on generalities.

To accomplish this more simplified focus, let's take a look at an example 401(k).

The 401(k) ROR Example

Okay, let's dive into an example. We'll use a 401(k) because that is one of the most common types of investments -- and therefore one of the most relatable.

Let's say Sally has a 401(k) for $10,000. She has been steadily investing for years, and her employer matches her investment. To make things simple, we'll say that the entire $10k was her initial investment, which includes how much money she put in and how much cash the employer matched.

Sally decided to invest in an allocation model. At 25 years old, she went with the aggressive growth model, and for Sally, this decision paid off. Most of the stocks in the model showed a gain on the market, and the few stocks that experienced losses were balanced by the growth of the others. When all of the stocks' returns and losses are expressed as percentages and averaged, the aggressive growth investment model shows a return of 5% over the course of a three month period. This 5% is the Rate of Return.

The important point to note here is that the 5% ROR is an average of all the investments in Sally's chosen model. So some of the stocks may experience loss while others show gains; as long as they balance out to a positive ROR, Sally's on the right path. (The very important investment strategy used in model allocations is called diversification).

That's the Rate of Return in its most basic form. Now when you're looking at your next 401(k) statement, you'll know exactly what that ROR entails! Join us for more investment definitions in the weeks to come.

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