Many factors can cause an investment to have a negative rate of return (ROR). Poor performance by a company or companies, turmoil within a sector or the entire economy, and inflation all are capable of eroding the value of the investment.
Rate of return is the amount an investment gains (or loses) over a period of time. It is expressed as a percentage of the initial value of the investment. For example, if an investor purchases a mutual fund for $10,000. After one year, the fund has increased in value to $11,000. The investment's rate of return for the year is 10%.
Understanding Negative Rate of Return
An investment has a negative rate of return when it loses value over a measured time period. If, in the following year, the mutual fund described above decreases in value from $11,000 back to $10,000, its rate of return for that year is approximately negative 9%.
- A negative rate of return is a loss of the principal invested for a specific period of time.
- The negative may turn into a positive in the next period, or the one after that.
- A negative rate of return is a paper loss unless the investment is cashed in.
The rate of return is negative when an investor puts money into an asset that drops in value to a point below the amount paid by that investor. The rate of return might turn positive the next day or the next quarter. Or, it could decline further.
Consider an investor who buys stock in a company for $100 per share. During the following year, the company makes a series of ill-advised acquisitions, taking on plenty of debt that squeezes its cash flow. Sensing impending doom, stockholders dump their shares. Selling pressure pushes the stock price down to $75 per share. The investor's rate of return for the year is negative 25% due to the stock's poor performance.
Note that this is a paper loss. As long as the investor doesn't panic and sell, the company might make some smart moves, after which the stock price will recover and the loss will disappear.
A negative ROR can have many causes. An investor may buy an oil-heavy exchange-traded fund (ETF) a day before global oil prices hit the skids. The release of a single unpleasant economic statistic can cause millions of investors to see negative rates of return for a day or a season.
Inflation can exacerbate a negative rate of return. Hyperinflation can cause it.
And then there are the really big events that impact the entire economy. During the Great Recession of 2007-2009, the broader stock market lost more than 50% of its value. And the investment losses went well beyond stocks, touching everthing from real estate prices to the art market.
The Inflation Phenomenon
Inflation can affect an investor's rate of return in a different way. This is where real rate of return comes into play.
A stock that gains 10% during a year when inflation pushes prices up by 8% has a real rate of return of 2%. The investor has 10% more money but only 2% more purchasing power.
An investment with a positive rate of return in dollars will have a negative real rate of return if inflation exceeds the investment's gain.
During the late 1970s, for example, inflation spiked to extreme levels. Stock markets rose during the same period, albeit tepidly, but real rates of return across most sectors were negative due to hyperinflation.
However, the effects of inflation are most relevant to investors in fixed-income assets such as long-term bonds. If the investor buys a long-term bond with an interest rate that is locked into the currently available rate, and inflation then rises, the investor's real rate of return in terms of spending power will suffer.
HTG Investment Advisors Inc., New Canaan, CT
A negative rate of return on an investment can also be caused by calculation errors, like forgetting to include some of the cash flow. For example, if the investment has distributed dividends or interest during the period for which you’re measuring the rate of return, you need to include those cash flows when figuring the return rate. Or you might confuse two types of return: the arithmetic mean return (often called the simple average return) and the geometric or compound return over time.
For example, say a two-year investment goes up 50% one year and down 50% the other (the order does not matter). The simple average return is (+50 - 50) ÷ 2 = 0%. The compound return is -25% over the two years since you start with $100 and end with $75.