Image source: Getty Images.
Virtually every investor has the same basic goal: to achieve the maximum amount of investment growth at a tolerable level of risk.
Achieving that balance means knowing yourself as an investor. What level of risk are you comfortable taking? Are you a conservative investor who does not want to risk losing any or most of your principal? Are you a moderate investor who wants to protect your assets while increasing the value of your portfolio? Or are you an aggressive investor who is willing to take calculated risks with the expectation of achieving greater-than-average returns?
Which brings us to two important investment concepts: return and rate of return. Let's take a closer look at both.
What's return?
Investment return is the money you make or lose on an investment. Ideally, your return will be positive -- that is, your initial investment or principal will remain intact, and you'll end up with more money than you invested.
But all investments carry some level of risk of loss -- especially securities that are subject to market fluctuations, such as stocks, bonds, and mutual funds that invest in stocks, bonds or both. The changes can be positive, but they can also be negative, meaning you can wind up with less money than you initially invested.
For example, let's say you buy a stock for $30 a share and sell it for $35 a share. Your return is $5 a share minus any commission or other fees you paid when you bought and sold the stock. If the stock had paid a dividend of $1 per share while you owned it, then your total return would be a gain of $6 a share before expenses. However, if you bought at $35 and sold at $30, you would have lost $5 on your investment, not counting expenses. If you earned a dividend of $1 per share, your actual loss would be reduced to $4 a share. This brings us to the concept of "total return."
Total return = gain or loss in value + investment earnings
Total return is a measure of your profit or capital appreciation before taxes and commissions or fees. When you evaluate your return on an investment, you should separately assess the impact of these other important costs, as they impact your bottom line. In the example above, if the commissions you paid to buy and sell the stock -- plus any taxes you must pay on net capital gains -- totaled more than $5, then you would have lost money. If you invest in mutual funds, you'll find both total annual returns and after-tax annual returns in the fee table in the prospectus.
Rate of return
After determining the return on an investment, you may want to compare that return to returns on other investments. But the dollar amount by itself doesn't tell you the whole story. To see why, compare a return of $5 per share on a $30 investment with a return of $5 per share on a $60 investment. In both cases, your dollar return is the same. But your rate of return, which you figure by dividing the gain by the amount you invest, is different.
In this comparison, the rate of return on the $30 investment is 16.67% ($5 / $30 = 0.1666), while the rate of return on the $60 investment is 8.33% ($5 / $60 = 0.0833) -- just half.
Rate of return = total return / investment amount
You can evaluate the rate of return on savings accounts, bonds, mutual funds, and the entire range of investment alternatives in much the same way. The more you invest to get the same dollar return, the smaller your rate of return will actually be.
The other factor you have to take into account in evaluating your return is the number of years you own the investment. There's a big difference in realizing a return of 16.67% on an investment you own for just one year and realizing the same return on an investment you own for five years. Your annualized return over a five-year period would only be 3.13%.
Using return
Return can be a useful tool in evaluating whether the investments you own are performing the way you expect, especially when you compare their return to that of similar investments or an appropriate benchmark, such as a market index that tracks the return of a group of similar investments. Specifically, you might compare the annual return on a large company stock or the return on a large-company stock fund to the annual return of the Standard & Poor's 500 Index (S&P 500).
You can also use historical returns to compare the average annual return over time of different categories of investments, known as asset classes. The most common asset classes include stocks (equities), bonds (fixed-income securities), and cash or cash equivalents. The research firms that track historical returns have found that, both over the past century and during shorter 10-year cycles, stock has had the strongest return among the major asset classes, bonds the next-strongest, and cash equivalents the most stable but the lowest.
While the annual return for any asset class, or mutual fund investing in that asset class, may surpass its historical average in a given year or series of years, the return may underperform the average as well. Past performance rarely predicts future results. Don't assume your return on an investment will be substantially higher than the average return on that investment over time. In fact, there's no guarantee that it won't be lower.
To receive the latest Investor Alerts and other important investor information sign up for Investor News.
