Question

Why is the Rate of Return often used incorrectly or misused or misunderstood?

Answer 1

Rate of return is used incorrectly due to different reasons. The first reason is the generation of more than one rate of  return when cash flows are positive and negative together during the period of investment. It creates more than one IRR as well. The second reason is that it does not tell the absolute amount by which an investor is going to be profitable. So, a small investment with a higher rate of return, will give lower absolute value of the wealth, but a big investment, with lower rate of return, will give higher absolute value of the wealth. So, rate of return should not be the sole criteria to select the investment opportunity. The third reason is the selection of rate of return and the method to be used to calculate the rate of return. It can be expected rate of return, rate of return calculating profit in real values and or required rate of return. So, different investors choose different rate of returns due to their own risk profile.

It makes rate of return to be misunderstood by people and investors.