RATES OF RETURN : UNDERSTAND, MEASURE AND COMPARE What do rates of returns measure and why are they important? This is the metric most used to compare different investments. It is expressed as a percent because investment opportunities come in all sizes. The profits from an retail return on investment can come from income received during the holding period, and also capital gains from the eventual sale.
Together these are called the “total return”. When comparing investments always use the total return. Detailed instructions for measuring your own portfolio’s rate of return are on the page Keep Track. Are quoted rates of return comparable between investments? Each of the asset types in the box below has its returns normally calculated in a different way.
For most uses the results are ‘good enough’ for comparison. But for any fine-tuning of a decision take the time to translate the ‘normally’ calculated return into a ‘true’ economic rate of return. The ‘true’ economic rate of return is what most people’s understanding of it would be. Essentially these all refer to the same concept. Different terms are used in different contexts. The period used is one year. Any income paid early is re-invested to earn its own income for the remaining portion of the year, or considered to have done so.
That income-on-income is included in the end-of-year value. There are many different words used to describe the measurement convention used in different situations. Unfortunately people use different words for the same thing, and use the same word to mean different thing. Always clarify in your mind what is being meant, without preconceptions.
NOMINAL returns: Real rates of return are what is left after the rate of inflation has been subtracted from the nominal rate. Much analysis of historical stock returns uses real returns because all investors demand at least the rate of inflation in order to justify deferring consumption, so it is premium above inflation that matters. GDP is the yearly production of a country measured using the market value of items. Its year-to-year change is heavily influenced by the inflation increases of the transactions. This is the technically correct math but the simple subtraction is good enough. Effective rates” section below, where ‘nominal’ is used in another context. Cumulative returns measure the total increase in the value of an investment over a number of years, not just one year.
Sometimes this measurement is the simplest, and perfectly valid, when comparing investments with the same time frame. Most everyone thinks of rates of return in the context of a one year period. That percentage is ‘meaningful’ to people. They have certain benchmarks in their mind for comparison. They know the yearly rate for term deposits or for their bank’s Line Of Credit. They know the yearly inflation rate. When comparing investments, yearly rates are the most logical, because investment terms may differ.
Some people use the term “total return” when referring to cumulative return. TOTAL return : You hear the term Total Return used most often to clarify that both the capital gains plus all dividend and interest income is being measured in total. Stock indexes measure only the price changes of their component companies. But some indexes publish their Total Return variant that includes dividends paid and the income earned by the reinvestment of those dividends. You know how to calculate an arithmetic average. But the question is: “Do investors WANT to find an average return of a multi-year period? The arithmetic mean will always be larger than the geometric mean.
Fortunately, when you hear the term ‘average’ used by mutual funds or others in the finance industry, it almost always refers to the geometric mean that you DO want to use to compare investments. They use the term ‘average’ because that is the concept everyone understands. The greater the volatility of individual year’s returns, the greater the difference between the arithmetic and geometric means. Paper profits have had no transaction to prove their value. This distinction does not affect the method chosen to measure the rate of return. For example with credit cards, the interest expense for each day is calculated individually.
Only at month end are they added together and posted to your account. The total accrued up to any mid-month date does not affect the calculation of interest for subsequent days. Most investments have profits that compounds. If the mortgage payment is received, nothing is added to the principal. The frequency of compounding will always be at least as often as the scheduled cash flows. A monthly-pay mortgage will compound monthly and a weekly-pay mortgage will compound weekly. If it were not to compound, there would be no incentive to make the required payment – the eventual payment would be the same whether paid on time, or late.