Several factors can cause an investment to have a negative rate of return. Poor performance of a company or companies, turmoil within a sector or the entire economy, and inflation all are capable of eroding investment values.
Rate of return refers to the amount an investment gains over a period of time. It's expressed as a percentage of the initial value of the investment. For example, suppose an investor purchases a mutual fund for $10,000. At the end of one year, the fund has increased in value to $11,000. The investment's rate of return for the year, then, is 10%.
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 rate of return can be negative when an investor puts money into a company that, due to poor management or factors beyond its control, struggles during the period of investment. 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, skyrocketing its liabilities and squashing its cash flow without any corresponding revenue increases. Sensing impending doom, stockholders jump ship; selling pressure pushes the stock price down to $75 per share. The investor's rate of return, then, is negative 25% due to poor performance by the company.
Sometimes negative ROR is not caused by problems related to a single company or group of companies. Turmoil within a broad sector or the economy as a whole can result in negative rates of return. One example is an investor who purchases an oil-heavy exchange-traded fund (ETF) right before a supply glut causes the price of oil to plummet.
Another is the Great Recession of 2007-2009, during which the broader market lost over 50% of its value. Regardless of sector, most investments had negative rates of return during those years.
Inflation also affects rates of return. The return on an investment minus the amount of inflation over the same period is the investment's real rate of return. A stock that gains 10% during a year when inflation pushes prices up by 8% has a real rate of return of 2%. Even though an investor has 10% more money, his purchasing power is only 2% greater. An investment with a positive rate of return in dollars can have a negative real rate of return when inflation exceeds the investment's gain.
During the late 1970s, for example, inflation spiked to high levels. Although stock markets were rising during the same period (albeit tepidly), real rates of return across most sectors were negative due to hyperinflation.
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.