A financial return, in its simplest terms, is the money made or lost on an investment over some period of time. Returns can be expressed nominally as the change in dollar value of an investment or as a percentage derived from the ratio of profit to investment. Returns encompass various metrics and can be net (after fees, taxes, and inflation) or gross (pure price change). This even includes investments like your 401(k).
Key Takeaways
- A return represents the price change of an asset, investment, or project over time, in terms of price change or percentage change.
- Positive returns indicate profit, whereas negative returns signify a loss.
- Returns are often annualized for comparison, with holding period returns showing the gain or loss for the entire holding duration.
- Real returns account for inflation and external factors, making them more reflective of true capital value change compared to nominal returns.
- Total return from stocks includes price change, dividends, and interest payments.
Discovering a Return
Savvy investors understand that the precise definition of return varies with the financial data used to measure it. For example, terms like profit could denote gross, operating, net, before-tax, or after-tax profit, and terms like investment could imply selected, average, or total assets. A holding period return measures an investment’s return over the time owned, expressed nominally or as a percentage. It can apply to durations ranging from months to years, often annualized for consistency.
Exemplifying Nominal Returns
A nominal return is the net gain or loss in dollar terms of an investment before adjustments for external factors like taxes, fees, dividends, or inflation. For instance, if an investor purchases stocks worth $1,000 and sells them two years later for $1,200, the nominal return would be $200 ($1,200 - $1,000).
Real Returns Unveiled
Real return adjusts nominal return for price changes due to inflation or other factors, maintaining the purchasing power of capital over time. Knowing real returns is crucial, as inflation and taxes can gnaw away at nominal returns. Real returns provide a clearer image of an investment’s true value, especially during high inflation periods.
Exploring Return Ratios
Return ratios evaluate how efficiently an investment is managed. Examples include Return on Investment (ROI), Return on Equity (ROE), and Return on Assets (ROA). These ratios help in comparing net income relative to various investments, providing a standard measure of financial performance.
Return on Investment (ROI)
ROI measures the return per dollar invested. It’s calculated by dividing the return in dollars by the initial investment and multiplying by 100 to get a percentage. For example, a $200 return on a $1,000 investment gives an ROI of 20% (i.e., $200 / $1,000 * 100).
Return on Equity (ROE)
ROE measures profitability, calculated as net income divided by average shareholder’s equity. For instance, if a company generates $10,000 in net income with average equity of $100,000, the ROE would be 10%.
Return on Assets (ROA)
ROA determines how much net profit is generated for each dollar invested in assets. Calculated as net income divided by average total assets, it shows how effectively assets are used. If a company earns $10,000 in a year with total average assets of $100,000, the ROA is 10% ($10,000 / $100,000).
Yield vs. Return: Understanding the Distinction
While sometimes used interchangeably, yield specifically refers to the income generated by an investment as a percentage of its price or face value. In contrast, return encompasses both income and capital gains or losses arising from price changes. For instance, a bond with a face value of $1,000 yielding a $50 annual coupon has a 5% yield, whereas return also includes market price changes.
Common Questions: Let’s Clarify Your Doubts
Is it possible to have a negative return?
Yes, a negative return signifies a loss, while a positive return indicates a profit.
What is the risk-return tradeoff?
This concept states that riskier investments must offer higher expected returns to compensate for the additional risk of loss. For instance, government bonds usually have lower returns than high-risk securities like growth stocks.
What are gross return and net return?
Gross return is the absolute price change plus any income over time. Net return deducts commissions, fees, and taxes from the gross return, reflecting what you actually pocket. Real return further adjusts for inflation.
How does diversification impact returns?
By investing in a variety of securities across different sectors and asset classes, diversification can enhance returns while minimizing the risk of any single investment adversely affecting your portfolio. Proper diversification can lower volatility and improve overall expected returns.
The Bottom Line
Return measures the gain or loss generated by an investment over time. A positive return indicates profit, while a negative return signifies a loss. Returns are often quoted as percentages and consider both income generated and capital gains. Higher returns typically require accepting higher risks.
Related Terms: investment, profit, 401(k), dividends, interest, capital gains, inflation.
