The goal of the investment process is generating income or appreciation via acquired assets. For the uninformed, appreciation is when something increases with time, and when an investor attains something in their ownership, they hope it will grow in value. In other words, to create wealth for them, usually in the long term. The three main objectives of most investing endeavors are financial stability, passive income generation, and producing capital gains. Secondary ones include tax minimization and keeping pace or outperforming inflation.
Though not as many people are investing right now as in the mid-2000s, the figure is closely approaching the pre-housing market crash era. Much of the resurgence of people buying securities also gets credited to the technological advancements of these past two decades that have made equity trading so simple. These also make measuring investment returns easier than ever, and many casual, aggressive, and conservative traders use these as a metric to check the well-being of their assets. Hence, precisely gauging returns is of super importance, and this article goes into virtually everything newbie investors should know on this topic in a concise manner.
Understanding Investment Returns
In short, an investment return is a change in the price of an asset. Naturally, a positive one, represented as profit, is an increase in value, and a negative return gets jotted down as a loss. A return may get expressed as a dollar amount or a percentage derived from the profit-to-investment ratio. They can also be depicted as net results (after taxes, fees, and inflation) or as gross figures that do not factor in anything aside from the price change.
For stocks, total returns should also factor in dividend and interest payments that affect the price of the asset’s price change. Know that returns often get annualized for rudimentary comparisons. Though, they can categorize using any period convenient for whatever purpose necessary.
Experienced traders grasp that the term return could have multiple contexts, and it is situational and dependent on the financial information input used to measure it. An investment could refer to select, average, or total assets, whereas profit could mean operating, gross, net, after, or before tax.
To vital ratios to know are ROI and ROA. The acronym ROI stands for return on investment and is a performance measure. Its role is to appraise the profitability or efficiency of investments. As a metric, it can be utilized to rank investments in different projects or assets or make apples-to-apples comparisons. ROA, or return on assets, on the other hand, is a profitability ratio that gets calculated as net income divided by average total assets. The latter gauge how much net profit has gotten produced for every dollar poured into assets.
Something that can also pop up is ROE – return on equality, calculated by dividing the net income by the total equity.
The Importance of Accurate Calculation
It is essential that every investor out there has the know-how necessary to properly calculate the returns their investments are generating because that is how they know where their portfolio stands and if rebalancing is in order to get it back on track to reaching predetermined goals.
If one inaccurately calculates their returns, called bad financial reporting, that can lead to erroneous choices, such as unintentional mistakes, and in some rare cases, even fraud. Reading data wrong will cause an investor to have a false picture of the health of their portfolio, potentially making them keep assets that are not doing as well as believed for too long or sell off ones that are worth keeping, among a myriad of other potential issues.
The damages done not only result in a loss of funds but also wasted time and human resources, not counting possible fines, penalties, and harm to one’s reputation and credibility originating from moves motivated by wrong data readings.
How to Calculate Investment Returns Accurately
While the answer concerning figuring out returns may seem simple – take the ending and beginning values, and the difference says it all. Right? Wrong. Things get a bit more complex than that in the investment sphere. People add money to investments, they remove them, and investments can have different income and cost streams. Hence, investors account for the holding period, the cash flows, and potentially other factors when coming up with returns.
The three most popular approaches to this undertaking get described here.
Simple Return Method
We somewhat already got into this technique above. It requires only two inputs, an investment’s increase in accounting net income divided by its cost. It is an easy and swift calculation that measures additional profit annually, giving an overall indication of the attractiveness of an investment.
Aside from speed, the other chief benefit of the simple return is that it is a reasonably accurate way to assess if an asset is doing well. Though, this is not something that many high-level traders prefer utilizing with any degree of regularity.
Time-Weighted Return Method
Here is an operation that multiplies the returns for every holding period or a sub-one, which connects them to show how the returns, over time, have gotten compounded. It removes the distorting influence of growth rates produced by outflows/inflows of funds.
In other words, the TWR breaks up the return on a portfolio into distinct intervals determined based on the fact that money got withdrawn or added to a fund. By creating this isolation, the TWR result is more accurate than the one supplied by the simple return method.
Money-Weighted Return Method
The MWRR accounts for the timing and size of withdrawals and deposits. Investors and analysts come up with it by finding the rate of return, which defines the current values of money flows equal to the initial investment value. Note that this measure is analogous to the IRR, or internal rate of return. It sets the initial value of an asset to equal ensuing cash flows like sale proceeds, dividends added, deposits, and withdrawals. Also, the money-weighted return often gets compared to the time-weighted one, though they are distinctly different. That said, if there are no cash flows, these two methods will supply identical or close enough results.
Factors to Consider When Calculating Investment Returns
As everyone knows, investments carry risk, which can vary depending on many things, including the potential profitability a trade makes. As a rule of thumb, safer investments bring less hazard than those that can yield mouth-watering rewards, which traditionally feature higher levels of uncertainty.
Thus, investors must discover their risk tolerance before giving their money in the hands of the market and also figure out their starting balance along with their contribution sums/frequency in this process. Most experts claim that an average investment return of 4% is a satisfactory milestone that casual low-to-mid-range investors should target. So, keep that in mind, and remember it takes years before most cautious traders pay off respectable amounts.
Various factors impact investment returns. There is no exhaustive, all-encompassing list, with some having much more influence than others. For one, investor behavior likely has the most dramatic impact, with this phrase communicating conduct dictated by greed, panic, overconfidence, and so on. Time impacts investment returns in several obvious ways, and then the cost linked with this practice land, such as advisory and management fees, on top of income and capital gains taxes.
Small but cumulative charges can pile up and become more substantial than what anyone first predicts. They can sneak up unexpectedly, like when an investor directs a broker/advisor/manager to perform actions on his behalf, which incurs a fee, and in the form of capital gains taxes. These are a concern in rebalancing periods, when investors restructure their portfolios by selling off assets to buy new ones. That procedure can incur expenses that are not negligible in the slightest. These must get accounted for as costs that have affected the value of a portfolio or asset.
Of course, in addition to these, market forces are also continuously in play. Yet, all these affect investments’ performance, but not how one calculates a return. When looking at the profitability of an investment, newbie traders must be aware of the difference between cash flow and gains, know not to underestimate intimal costs, and grasp what cycle/period to account for that correctly depicts an asset’s strength.
To Sum Up
It is absolutely crucial that all individuals trading securities take time to check periodically the returns their investments yield. A stream of negative ones from a given asset is a cause for worry and maybe a signal for portfolio rebalancing.
There are several ways one can appraise their performance as an investor. But, without question, looking at overall portfolio returns is the most revealing. Various ways exist to generate this measure, but most knowledgeable traders favor the time-weighted and money-weighted methods.
The consequences of inappropriately quantifying profitability can be seismic. Hence, that is why it is best to use technology like tracking/trading apps packed with one’s investment data when calculating returns. These pieces of software do most of the work automatically and leave little room for error.