In investing, effective rate of return is the actual return an investor will see on a stock, bond or other investment vehicle. To receive a more realistic return rate, compounding is taken into account. While, in many ways, effective rate of return and stated return — which represents the flat payment an investor will receive on investment vehicles — may seem to clash, they tend to work together. Returns can be annual, quarterly or monthly, so the effective return rate will be different based on how often interest is added onto the investment vehicle. This method of figuring out return rates is better for realistic payment measurements, but it is not always used because it often leads to long numbers.
Many investment vehicles receive compounding interest; this is when the interest adds to the previous investment’s value. For example, if the investment is worth $10 US Dollars (USD) and the interest is 10 percent, then the investment will grow to $11. If there is no compounding, it will be $12 USD the next payment time; with compounding, the 10 percent will be added to the $11 USD total instead of the $10 USD base, equaling $12.10 USD. When effective rate of return is used to measure how much an investment will grow, this compounding is taken into account, unlike stated annual return, which is only based on the percentage of each payment — in this example, 10 percent.
Stated and effective rate of return may seem to conflict, because one uses compounding while the other does not; in reality, they do not conflict. If there is no compounding on an investment vehicle, then both the effective and state rates will be the same. The effective return rate uses stated return as a base, which makes them work together; this means investors must know the stated return to figure out the effective return. Most investment vehicles permit compounding, so it is very rare for the two return rate measurements to turn out the same.
To calculate effective rate of return, the investor must know how often payments are made. Payments can be made annually, quarterly or monthly; this is because the effective rate is based on how much extra money the investor will make in a year. If interest is added quarterly, then the investor will need to calculate how much compounded interest he or she will get from four payments; if payments are monthly, then the investor calculates interest based on 12 payments.
Using effective rate of return is popular among investors who want to know the exact amount of interest added to an investment vehicle in a year. At the same time, the effective return may not be used in conversation because it leads to longer numbers that are awkward to say. For example, the stated rate may be 10 percent, but the effective rate may be 10.32456 percent; in this instance, investors may just say 10 percent in conversation. Investors who just want a snapshot of the return rates may avoid effective rates.