Calculating your investment returns
Ever wonder how to calculate the success (or failure) of your investment portfolio? Well, many investors use investment returns, which is the percentage change in the total value of your investment over a period of time.
For instance, if your portfolio began with $100 and is now worth $110, your investment return is 10% ($110 minus $100 is $10, and $10 of $100 is 10%). Professional investors often calculate returns over annual periods, but this isn’t always the case. That’s why it’s important to understand how returns are calculated to properly interpret them.
Breaking down investment returns
Returns are made of two parts -- the change in the price of an investment (increase or decrease) and any cash flow from that investment, such as dividends or interest. For example, when you invest in stocks, not only will their prices change over time, but you’ll usually receive dividends as well. The same is true for investments such as bonds, which may pay interest. The greater the rise in price or the larger the dividend/interest payment you receive, the greater your return will be. By adding up the total value of all of your investments, you can calculate the total return of your portfolio.
Fees may reduce your returns
It’s important to remember that your investment returns are reduced by various investment fees such as commissions, management fees, and expense ratios. When you buy and sell investments, such as in a brokerage account, you often pay commissions on each transaction. When you invest in a fund, including mutual funds and ETFs, there are often fees you pay over time, measured by “expense ratios.” These commissions and fees reduce your overall investment returns. Thus, it’s always important to consider trading and investing carefully to determine whether the potential gains, which are uncertain, are worth the expenses, which are guaranteed.
Making up for investment losses
One quirk about measuring returns with percentages is that they are asymmetric – i.e. you need a larger percentage gain to make up for a percentage loss. As a simple example, imagine again that you begin with a $100 investment. If there is a significant event in the financial markets and you lose 50% of that value, your investment is now worth $50 (50% of $100 is $50, and $100 minus $50 is $50). What investment gain is needed to return to $100? Unfortunately, it’s not 50%, since that would increase the value of your investment to only $75 (50% of $50 is $25, so $50 plus $25 is $75). In this case, you would need a 100% return! While this is a technical point, it’s important to keep in mind when thinking about investment returns.
Higher returns may come with higher risk
When creating a financial plan and asset allocation, investors need to understand how investment returns will help them reach their goals. Additionally, all investment returns come with levels of risk that investors also need to manage when developing their financial plans. Generally, investments that produce higher returns also come with higher levels of risk. Investors need to understand their appetite for risk as well as their ability to take on risk when developing an investment plan.