Investors have many methods to use to determine rate of return on investment vehicles, depending on the factors they want to consider. The stated rate is the most basic method to determine rate of return, because it only considers the percentage of interest paid. Effective rate of return takes into consideration compounding, which is present on most investments. Internal rate of return is based on how much money is in an account or investment vehicle, so the return can dynamically alter. Time-weighted return is the opposite of internal rate of return, because it does not matter how much money is in an account.
Stated rate of return is the most basic method for investors who want to determine rate of return, because no math is required and investors will typically know this number before investing. The stated rate is the interest rate that will be added to an investment. For example, if the interest rate is 15 percent, then this also is the stated rate. Unlike effective and internal rate of return, it does not matter how much money is in the investment vehicle, nor does it matter if compounding — extra interest added on top of the investment’s current value, as opposed to its base value — is used.
The effective rate of return is often used on static bonds and stocks that do not increase or decrease in value based on an investor’s actions, unlike a bank account that allows an investor to add or remove money. Using this measurement to determine rate of return often happens when the investment vehicle has compounding, because effective rate of return is specifically made to account for compounding. If there is no compounding, then effective rate of return can still be used, but it will often turn out to be the same as the stated return.
An internal rate of return is similar to the effective return rate, but this is used for bank accounts or other investment vehicles that allow the investor to add or subtract money from the investment. For example, if the interest rate is 10 percent and an account has $100 US Dollars (USD), then the return will be $110 USD; if the account has $200 USD, then the return will be $220 USD. This leads many investors to try to add money to their accounts or investment vehicles before the payment time.
With time-weighted return, it does not matter how much money is in an account. To determine rate of return, investors are typically given a flat number or a static interest rate is applied to a base amount of money. For example, if the return is $10 USD — or it may be 10 percent of a base amount of $100 USD — it does not matter how much money the investor has in an account, the return will still be $10 USD. This type of return rate is much safer, because investors are practically guaranteed a payment, regardless of an investment vehicle’s current value.