Performance, rate of return, and compounding are big topics in finance.

And it’s not just the guy at the dinner party showcasing that he “tripled” his money on Bitcoin. It’s the interest rate that you earn on your checking account. And it’s in the red and green numbers you see all over the place when you log on to your investment account.

So, what does it all mean? How do we interpret it? And, most importantly, why does it matter?

Stepping back, there are two components to your rate of return: (1) growth, and (2) time.

Here’s a breakdown of each:

Your rate of return, or simply “return,” is the growth component. It tells you how much your money increased (or decreased) from start to finish, no matter how long it took. And this rate of return is measured as the percentage change between what you paid for an investment and what you sold it for.

For example, let’s say you buy a house for $250,000 and later sell it for $350,000.

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

This is how you calculate the overall return: ($350,000 − $250,000) ÷ $250,000 = 0.40, which is an impressive 40% return.

This same formula generally applies whether you are evaluating a house, a stock, or a bottle of wine. You can compare where you started to where you ended. That percentage difference is your rate of return, and that percentage answers one simple question: how much did my money grow?

However, rate of return alone does not answer the other key question, which is: How quickly did that growth happen?

This is where the second component, time, comes into play.

To continue the same example, let’s say that the house you bought increased from $250,000 to $350,000 in one year. The annualized rate of return on the house would be 40%, because the growth happened within a single year.

But if that same increase had happened over five years, the annualized return would have been much lower. The overall return is still 40%. That never changes, but spreading that same gain over more time reduces how much you earn per year. The annualized return is 7% per year. Still solid, but not an eye-popping 40%.

Specifically, here’s how that 7% per year breaks down:

Year 1
$250,000 × 1.07 = $267,500

Year 2
$267,500 × 1.07 = $286,225

Year 3
$286,225 × 1.07 = $306,261

Year 4 and Year 5 continue the same pattern, with each year’s return applied to a larger balance. Toward the end of the five years, the value approaches $350,000. The same sale price, but it took longer to get there, which is why the yearly return is lower.

So, if the overall rate of return tells you how much you made from beginning to end, annualized return breaks that number down and tells you how much your money grew, on average, each year.¹

Bottom line: Whenever someone tells you that their rate of return was X%, the next logical question is always: over what time period? Two days? Three years? A decade? The rate of return has a growth component and a time component.

When you log on to your brokerage account, you’ll be bombarded with red and green percentages. Those percentages on the homepage typically show how much your account is up or down today. It’s an intraday timeframe—a snapshot.

Then, if you click on “Positions” inside your investment account, you can see, for each investment, how much that individual investment is up or down today (i.e., “Today’s Gain/Loss”), and also how much that investment is up or down since you first purchased it (i.e., “Total Gain/Loss”).

Emotionally, it’s easy to anchor on those red and green numbers—both the intraday snapshot and the overall gain or loss. I’m certainly guilty of it. When I log on and see green, I feel great. And when I log on and see red, I feel like someone punched me in the gut.

But the reality is that the daily fluctuations in our portfolios don’t really matter so much. Instead, on a day-to-day basis, I focus on whether the price architecture underlying each one of my investments is solid.

Zooming out, on a longer-term basis, I focus heavily on my annualized rate of return. (If you go into the “Performance” tab on your brokerage firm’s website, you can see your annualized rate of return for any given year.)

To put these performance numbers into context:

Ultimately, all of my investing efforts are in service of trying to make my account balance go up steadily over time—ideally without a lot of big drops or drama along the way.

Yes, there are ups and downs each day and tough markets that can last months on end.

But my goal is to grow and compound my account because that ultimately supports the life I want to live.