In our first look at investment returns, we reviewed a few common return calculations.
If you know the formulas, the calculations are quite simple. The key is to know what is included and excluded from the different returns.
But even with the hard calculations, returns can mean different things to different investors.
Today we will consider some of the qualitative aspects in evaluating investment returns.
Return, like risk, is in the eye of the beholder. Never be seduced simply by the quantitative side of investment returns. Always look at results from a other angles as well.
I think this is just as important as the hard numbers.
Unfortunately, it is an area many investors ignore to varying degrees.
Do so at your own peril.
Expected Rate of Return
Before we get into today’s session, I quickly want to review a topic we have previously discussed.
Expected return is the anticipated asset performance for the future period under consideration.
There are a variety of ways to calculate expected returns and most incorporate multiple variables.
Historic returns, probability and scenario analysis, company specific expectations, general market and industry specific expectations, risks, risk-free returns, etc. There are many factors that go into determining an asset’s expected return.
Because these returns are expected, there is a probability that the actual results will differ.
This is where our earlier discussions of standard deviations come into play. The larger the standard deviation (i.e. the greater the volatility of the asset), the less likely that the actual return will equal the expected return.
As the level of risk lessens, the certainty of the result rises. It is only in investments that have no risk that the expected return will always match the nominal return.
In our analysis below, we shall use this simple example.
You invest $1000 in an asset on January 1. You sell the asset December 31 for $1250. There were no cash flows so your total return (also, in this example, your holding period and annual returns) is $250 or 25%.
Nominal Rate of Return
While expected returns are forward looking, nominal returns reflect what actually occurred.
This is the most common way to express a return.
The nominal return is the investment return unadjusted for any other factors. In our example, the nominal return is 25%.
A good number to know. But on its own, there is no context.
And we always need context. Well, at least those who want to properly invest do.
How do we put nominal returns in context? You need to use comparative data.
Real Rate of Return
The real rate of return adjusts the nominal return to eliminate any impact from inflation.
We discussed the affect of inflation previously.
Let’s say that your investment above was made in the United States where the annual inflation rate is running at 3%. Your real rate of return therefore is only 22% (25% nominal minus 3% inflation).
Not too significant an impact.
However, perhaps you live in Venezuela where inflation is about 30% annually. Your real return becomes a loss of -5%. Even though you made a 25% profit (on which you will be taxed), you have actually lost 5% in purchasing power over the year.
When investing, always consider the impact of inflation on your returns. Its impact on your real returns can be substantial.
Risk-free Rate of Return
The risk-free rate of return is the return on an investment that carries no risk.
That is, the outcome or return is known with 100% certainty. If the expected return is 10% or $100, you are fully guaranteed the result.
While it is debatable as to whether any investment can be termed risk-free, for investment purposes certain government short term debt issues are considered to be certain. In the United States, the 13 week US Treasury Bill (T-bill) is considered to be a risk-free investment at this time.
Why is knowing the risk-free rate of return important?
It is believed that investors are rational creatures. That means that all else equal, investors will choose the more efficient investment option when faced with two choices.
Efficiency, in this case, refers to the relationship between risk and return. When having a choice between two investments of identical risk, investors will always select the asset with the higher expected return. Alternatively, when choosing between two investments with identical expected returns, investors will choose the asset with the lesser risk.
While not always followed in practice, it should make sense.
For example, say 13 week US T-bills offer a effective, annual return of 10%. In essence, the risk-free rate is also 10%. That means you could invest in T-bills and be guaranteed a nominal annual return of exactly 10%.
Since all other investments have a higher level of risk, rational investors will never accept less than a 10% expected return for a risky investment.
The greater the risk, the higher the return demanded by the investor.
US government bonds are less risky than most corporate bonds. Therefore, if you look up yields on different bonds, you will see higher yields on corporate versus US government bonds with the same characteristics.
Similarly, riskier companies must pay higher interest rates than more secure companies.
This is the same as personal loans from your bank. If you are a valued client with lots of assets, you might get a loan at the prime interest rate. But if you have no track record of repayment or have had difficulties making debt payments in the past, you will need to pay higher rates than prime.
Use the risk-free rate of return as a minimum benchmark when considering investment options.
If the risk-free rate is 10% and you are contemplating an investment with an expected return of 15% and standard deviation of 10%, you might give pause. Yes, the potential return is higher than US T-bills, but the risk is significantly higher. In fact, 95% of the time, your actual return will be anywhere between 35% (good) and -5% (not so good).
Whether you think this is a better investment than the T-bills is based on your own risk tolerance.
But by knowing the risk-free rate, you have additional information to make better decisions.
Relative Rate of Return
With the real and risk-free rates of return we considered investment options relative to inflation rates and guaranteed returns respectively.
But you should also compare your investment returns to other benchmarks. These include: prior year results; analyst or company expectations; the market as a whole; the industry in which the asset lies; predetermined benchmarks.
In our example, the nominal return was 25%. Sound’s good.
Actually, I have no idea if it is good or bad. I need more information.
Perhaps the investment in our example was Fantasy Bank shares.
I would be interested in how the shares performed over the previous years. If the 5 year average return was 40%, maybe 25% this year is relatively weak.
What if I told you the general stock market grew 12% over the year and that the average banking industry shares rose 30%. You would be happy that your stock outperformed the general market return, but unhappy that you underperformed other banking stocks.
When examining potential investments, you consider the expected returns. For many investments, analysts and industry experts have expectations for the coming year’s returns. If analysts had predicted that Fantasy would grow by 50%, you might be disappointed with 25%. Especially if you based your investment on a risk-return profile incorporating the 50% expected return.
You can set up a variety of other benchmarks to compare performance. But you should always compare your actual and expected returns relative to predetermined criteria.
That gives you a few thoughts as to why you should never consider investment returns in isolation.
Always compare your actual and expected returns agains relevant benchmarks.
Your decision-making and portfolio performance will benefit.
Next in our investment series, some further evidence that all returns are not the same.