Performance, rate of return, compounding.

These words get thrown around constantly in finance. And it’s not just CNBC or the Wall Street Journal. It’s the guy at the dinner party who wants everyone to know he tripled his money on Bitcoin. (Cue the knot in your stomach.) It’s the interest rate on your checking account. And it’s the red and green numbers that light up your screen every time you log in to your investment account.

So, what does it all mean? How do we make sense of it? And, most importantly, why should we care?

Let’s break it down.

Every rate of return has two parts: (1) growth and (2) time. In other words, your rate of return is how much money you make plus how long it takes you to make it.

Let’s start with growth.

Your rate of return (or simply your “return”) tells you how much your money went up (or down) from start to finish, no matter how long it took. You calculate it by comparing what you paid for an investment with what you sold it for.

Let’s say you buy a house for $250,000. A few years later, you sell it for $350,000.

Purchase price: $250,000
Sale price: $350,000
Profit: $100,000

The math looks like this: ($350,000 − $250,000) ÷ $250,000 = 0.40. That’s a 40 percent return. Not too shabby.

The same formula works whether you’re looking at a house, a stock, or a bottle of wine. Where did you start? Where did you end up? The percentage difference between the two is your absolute rate of return, and it answers one simple question: How much did my money grow?

But it doesn’t answer the other question: How fast did it grow?

That’s where time comes in.

Let’s go back to the house. If it went from $250,000 to $350,000 in a single year, your annualized rate of return is 40 percent. All of that growth happened in one year.

Now let’s say that same increase took five years. Your absolute return is still 40 percent. That never changes. But spread over five years, it works out to about 7 percent per year. Still solid, but a far cry from an eye-popping 40 percent.

Here’s what 7 percent per year looks like:

Year 1
$250,000 × 1.07 = $267,500

Year 2
$267,500 × 1.07 = $286,225

Year 3
$286,225 × 1.07 = $306,261

Years 4 and 5 follow the same pattern, with each year’s return applied to a slightly bigger balance. By the end of year five, you land right around $350,000. Same sale price. It just took longer to get there, which is why the yearly return is lower.

So your absolute rate of return tells you how much you made from beginning to end. Your annualized rate of return tells you how much your money grew, on average, each year (or each month, or whatever period you choose).

And you can slice time however you like. One year (i.e., “annualized”) is the most common way to report it. But if you buy a stock and it goes up 3 percent in two days, then two days is your time period and 3 percent is your return. The shorter the time period, the bigger that return looks once you annualize it, and vice versa.

The takeaway? Whenever someone tells you their return was X percent, your very next question should be, Over what time period? Two days? Three years? A decade? Every rate of return has a growth component and a time component. Without both, the number can be deceptive.

Log in to your brokerage account, and you’ll be bombarded with red and green percentages. The numbers on the homepage typically show how much your account is up or down today. It’s a snapshot of a single day.

Click on “Positions,” and you’ll see two numbers for each investment: how much it’s up or down today (“Today’s Gain/Loss”) and how much it’s up or down since you first bought it (“Total Gain/Loss”).

It’s so easy to get emotionally hooked on those numbers. I’m certainly guilty of it. When I log in and see green, I feel great. When I log in and see red, it feels like someone punched me in the gut. And that’s okay. We’re human.

But the truth is, the daily ups and downs in our portfolios really don’t matter that much. Day to day, I try to tune out the noise. Instead, I ask two questions: Are the companies I own still financially healthy and growing? And is the economic environment still sound?

Zooming out, the number I do pay close attention to is my annualized rate of return. (You can find it under the “Performance” tab on your brokerage firm’s website, broken out by year.)

Why? Because your rate of return, more than almost anything else, determines the quality of your life.

To put those numbers in context:

If you compound your money at 4 percent per year, you risk losing a lot of it to inflation. You think you’re investing, but the sad reality of inflation in our economy is that it eats a lot of your spending power every year.

If you compound your money at 8 to 12 percent per year, that’s a really solid performance.

And if you can compound your money at 15 percent per year, year in and year out, you’re in the ranks of the best investors in the world.

At the end of the day, all my investing efforts serve one goal: helping my account balance grow steadily over time, ideally without a lot of big drops or drama along the way.

Yes, there will be ups and downs every day. There will be tough markets that drag on for months. And there will be moments when that knot in your stomach comes back.

But growing and compounding my money isn’t really about the money. It’s about what that money makes possible: more freedom, more peace, and more space.