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The annual percentage rate, commonly referred to as the nominal annual rate or the yearly rate of return method, is a way to calculate the profitability of an investment over the course of a year.Â
It is computed by multiplying the fund's beginning-of-year value by the difference between its end-of-year and beginning-of-year values. The outcome is then multiplied by 100 to produce a percentage.
The formula for the yearly rate of return method is:
Yearly Rate of Return = [(End-of-Year Value - Beginning-of-Year Value) / Beginning-of-Year Value] x 100
As an illustration, let's say that at the beginning of the year, you put $10,000 into a mutual fund. The fund will be valued at $11,500 by the year's conclusion. Your yearly rate of return is:
Yearly Rate of Return = [($11,500 - $10,000) / $10,000] x 100
Yearly Rate of Return = [0.15] x 100
Yearly Rate of Return = 15%
This means that you have earned 15% on your investment in one year.
However, using the yearly rate of return method has the drawback of not accounting for the effects of compounding. When you reinvest your money and do so over time, this is called compounding. The yearly rate of return method merely examines the value change from year to year without taking into account how much money you could have made if you had invested your earnings throughout the year.
Another disadvantage is that it does not account for inflation. When the cost of goods and services rises over time, it is called inflation and it affects your money's ability to buy more things. The yearly rate of return technique solely evaluates the nominal worth of your investment and does not account for price fluctuations. The implication of this is that your real rate of return, which accounts for your actual earning ability, may be lower than your nominal rate of return.
The formula for the yearly rate of return method is:
Yearly Rate of Return = [(End-of-Year Value - Beginning-of-Year Value) / Beginning-of-Year Value] x 100
As an illustration, let's say that at the beginning of the year, you put $10,000 into a mutual fund. The fund will be valued at $11,500 by the year's conclusion. Your yearly rate of return is:
Yearly Rate of Return = [($11,500 - $10,000) / $10,000] x 100
Yearly Rate of Return = [0.15] x 100
Yearly Rate of Return = 15%
This means that you have earned 15% on your investment in one year.
How to Use the Yearly Rate of Return Method
The yearly rate of return method can be used to compare the performance of different investments over a single year. For instance, you can use the yearly rate of return approach to determine which fund has produced the most profit for you if you have two funds that you invested in at the same time and with the same amount of money.The yearly rate of return approach can also be used to assess your personal expectations and investment goals. The yearly rate of return approach, for instance, can be used to determine whether a target rate of return that you set for a year has been met or surpassed.
The yearly rate of return technique has several restrictions and disadvantages, though, that you should be aware of.
What Are Some Advantages and Disadvantages of the Yearly Rate of Return Method?
One benefit of employing the yearly rate of return method is that it is simple to comprehend and calculate. Only the initial and final values of your investment, which are two different values, are necessary. Any transactions or intermediate cash flows that may have happened throughout the year are not required to be accounted for.
It also clearly illustrates how your investment has fared over a given time frame, which is another benefit. You may examine your annual profit or loss, which will assist you in making wise selections regarding your upcoming investments.
However, using the yearly rate of return method has the drawback of not accounting for the effects of compounding. When you reinvest your money and do so over time, this is called compounding. The yearly rate of return method merely examines the value change from year to year without taking into account how much money you could have made if you had invested your earnings throughout the year.
Another disadvantage is that it does not account for inflation. When the cost of goods and services rises over time, it is called inflation and it affects your money's ability to buy more things. The yearly rate of return technique solely evaluates the nominal worth of your investment and does not account for price fluctuations. The implication of this is that your real rate of return, which accounts for your actual earning ability, may be lower than your nominal rate of return.
