Examples: #1: An investor invests $10,000 for one year and earns a $500 return on the investment. At the end of one year, the investor receives back $10,500. The investor’s rate of return on the investment is the $500 income received divided by the $10,000 invested: Annual Rate of Return = $500 ÷ $10,000 = .05 or 5% #2: What if our investor invests $10,000 for only 6 months and earns $250 on the investment? What is the investor’s rate of return now? Is it $250 ÷ $10,000 = .025 or 2.5%? No. We must annualize the $250 that was received for 6 months. We say, “What if this same $10,000 had been invested for a full year? At this rate, how much would the investor have earned?” To answer that question, we multiply the $250 by 2, since there are two 6-month periods in one year. We then divide the result by the amount invested to calculate the annual rate. Annual Rate of Return = ($250 × 2) ÷ $10,000 = .05 or 5% #3: Now, suppose our investor invests $10,000 for 3 months, then withdraws $4,000 and leaves the remaining $6,000 on deposit for another 3 months. At the end of 6 months, the investor withdraws the remaining $6,000 along with income received of $200. What is the investor’s rate of return? The average balance of the investment over the 6-month term was [($10,000 × 3) + ($6,000 × 3)] ÷ 6 = $8,000. The amount of income received for those 6 months was $200, and that is equal to $400 when it is annualized (multiplied by 2). We assume the average balance of $8,000 was invested for one full year, even though it was invested for only 6 months. Annual Rate of Return = ($200 × 2) ÷ $8,000 = .05 or 5% This is a “what if” scenario. What if this same amount of money had been invested for one year, on the same terms ($10,000 half of the time and $6,000 half of the time), and income had been earned on it at the same rate throughout the year as it was earned during the 6 months it was invested? That calculation gives us the annual rate of return.
Posted on: Wed, 24 Dec 2014 10:38:32 +0000
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