Today we shall start to look at the concept of investment returns.
A relatively straightforward concept.
The return is the gain or loss you experience on an investment.
Pretty easy compared to our risk analysis.
Or is it?
While the above definition applies, investment returns are slightly more complex.
There are a variety of return calculations. The importance of each depends on the individual investor’s personality and circumstances.
Below we will look at three common return calculations.
Total Return equals:
(Sale Proceeds – Purchase Price + All Cash Flows + Reinvestment Income)/Purchase Price
Net cash flows include interest and dividend income. It may include interest expense on any debt used to finance the investment. And taxes payable on any gains or income incurred.
Transaction costs are sometimes factored into net cash flows. I prefer to add them to the purchase price and deduct them from the sale proceeds. Alternatively, you can track them separately as investment expenses should you so desire.
Reinvestment income is the income you earn on income received. Much like in our discussion of compound returns.
For example, you purchase one share of ABC for $10. You receive a dividend of $1.00. You put that cash dividend receipt into your personal savings account and earn $0.10 in interest. You then sell the share for $12.
Total Return is the capital gain (sale proceeds minus purchase price), the dividend income (net cash flow), and the interest income earned from the cash dividend (reinvestment income). In this example, it is $3.10 or 31%.
When calculating, investors often forget to factor in the reinvestment income.
31% sounds like an excellent return on ABC. But is it?
Total Return relates to the return over a period of time. That period may be any duration. One day, one year, one century.
What if I told you that you bought and sold the stock in one week. Then the return is impressive. But what if I said that you bought the stock in 1970 and sold it in 2010. On an annual basis, 31% over 40 years may not be that attractive.
Or what if I offered you two investments. One provides a Total Return of 100%. The other, 10%. You would obviously be tempted by the first. However, if the holding period for option one is five years and only five weeks for option two, your decision might change.
That is a big problem when people speak of Total Returns. Without any context of time, it is hard to assess the relevance of total return as a performance measurement.
So when someone talks to you about returns, make sure you put it in a time context.
A simple way to calculate Annual Return is modify the Total Return calculation,
Annual Return equals:
(Value at End of Year – Value at Start of Year + Year’s Net Cash Flow + Year’s Reinvestment Income)/Value at Start of Year
This formula acts as if you bought the investment at the start of the year and sold it at year’s end.
In using this formula, you can quickly compare performance of different investments over the same time horizon.
Holding Period Return
You may also come across something called a Holding Period Return.
HPR = (Ending Value/Beginning Value) – 1.
This is like the Total Return except it does not include net cash flows nor reinvested income.
If you invest in assets with significant cash flow aspects (e.g. bonds, preferred shares), you will be missing out on a material portion of actual return by ignoring cash flow and reinvested income.
But if you invest in common shares of small capitalized (“small cap”) growth stocks you likely will not receive any dividend income. In this case, Holding Period Return will equal Total Return.
You can calculate Holding Period Return for any combination of time periods. Just determine a beginning and end date and you are set.
A Lesson to Remember
There are other returns that you will see. We may consider a few more in due course.
If you learn the equations, or have a decent financial calculator, calculating investment returns is not difficult.
But always remember to compare apples to apples and oranges to oranges when calculating and analyzing returns.
Depending on the asset and conditions, different return calculations can yield materially different results.
Make certain that you use the correct ones to arrive at the best conclusions.
And if someone tells you the expected or historic returns are 15% (for example), make sure you know exactly which type of return they are using.
With a variety of return options, you will usually be informed of the one that is most favourable to the person telling you. And that may not be in your best interest.