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Economic total return

What Is Economic Total Return?

Economic total return is a comprehensive measure of an investment's performance that extends beyond conventional accounting figures to consider the true economic gain or loss, factoring in elements such as the erosion of purchasing power due to Inflation and the Opportunity Cost of capital. This perspective falls under the broader umbrella of Investment Performance Measurement, aiming to provide a more holistic view of an asset's or portfolio's success. Unlike simply tracking price changes or reported Profitability, economic total return seeks to reflect the real increase in an investor's wealth after accounting for all relevant economic factors. It helps investors understand the genuine economic benefit derived from their Investment Portfolio.

History and Origin

The concept of evaluating investment performance has evolved significantly over time. Initially, focus was largely placed on easily quantifiable financial metrics reported on Financial Statements, such as nominal gains and dividends. However, as financial markets became more complex and economic theories advanced, it became clear that such measures often presented an incomplete picture. The recognition of factors like inflation's impact on money's value and the foregone benefits of alternative investments spurred the development of more sophisticated performance metrics.

The push for standardized, transparent, and comprehensive investment performance reporting gained significant momentum in the late 20th century. The CFA Institute, for instance, developed the Global Investment Performance Standards (GIPS), which aim to ensure full disclosure and fair representation of investment results to clients. This initiative, alongside academic research into concepts like Real Return and Risk-Adjusted Return, contributed to a broader understanding that a truly "total" return must encompass more than just nominal price appreciation and income distributions. The emphasis shifted towards evaluating the economic substance of returns.

Key Takeaways

  • Economic total return provides a holistic view of investment performance by considering both explicit financial gains and implicit economic factors.
  • It adjusts for the impact of inflation, offering a real measure of wealth growth or decline.
  • The concept incorporates opportunity cost, recognizing the value of the best alternative use of capital.
  • It aims to provide a more accurate assessment of an investment's success from a wealth-building perspective, beyond mere accounting figures.
  • Understanding economic total return is crucial for long-term strategic investment planning and evaluating the true effectiveness of capital allocation.

Formula and Calculation

While there isn't a single, universally defined "economic total return" formula that deviates from the standard total return calculation for specific assets, the interpretation of total return from an economic perspective involves adjusting for implicit costs and inflation to derive a real, rather than nominal, gain.

The basic formula for total return (nominal) is:

Total Return=(Ending Value−Beginning Value+Income)Beginning Value\text{Total Return} = \frac{(\text{Ending Value} - \text{Beginning Value} + \text{Income})}{\text{Beginning Value}}

Where:

  • Ending Value: The market value of the investment at the end of the period.
  • Beginning Value: The market value of the investment at the start of the period.
  • Income: All cash flows received from the investment during the period, such as Dividends, Interest Income, or distributions.

To arrive at an economic total return, this nominal return is typically adjusted for inflation to reflect the real purchasing power gain. This results in the real return formula:

Real Return=(1+Nominal Return)(1+Inflation Rate)−1\text{Real Return} = \frac{(1 + \text{Nominal Return})}{(1 + \text{Inflation Rate})} - 1

Furthermore, from an economic perspective, the "income" and "value" components implicitly account for all forms of economic benefit, including capital appreciation (or Capital Gains) and income. The concept of economic total return primarily emphasizes the implications of these calculations, particularly concerning opportunity costs and real purchasing power, rather than introducing entirely new mathematical variables for a numerical calculation.

Interpreting the Economic Total Return

Interpreting the economic total return involves looking beyond the raw numerical percentage and considering what that return truly means for an investor's purchasing power and wealth creation. A positive economic total return indicates that the investment has not only generated a nominal gain but has also outpaced inflation and compensated the investor for the Opportunity Cost of allocating capital to that specific asset rather than an alternative. Conversely, a zero or negative economic total return suggests that the investment either barely kept pace with inflation and opportunity costs, or that the investor's real wealth has diminished.

For instance, if an investment yields a 5% nominal total return, but inflation for the same period was 3%, the real return is approximately 1.94%. This demonstrates a real economic gain. However, if an investor could have earned 6% with similar risk elsewhere, the 5% nominal return (even with a positive real return) might imply a suboptimal economic choice from an opportunity cost perspective. Therefore, interpreting economic total return requires a nuanced understanding of both the Time Value of Money and the broader economic landscape.

Hypothetical Example

Imagine an investor, Sarah, who buys a piece of rental property for $200,000 at the beginning of the year. Over the year, she receives $12,000 in rental income. At the end of the year, the property's market value has increased to $208,000. During this period, the annual inflation rate was 3%.

First, let's calculate the nominal total return:

  • Beginning Value = $200,000
  • Ending Value = $208,000
  • Income = $12,000

Nominal Total Return = (($208,000−$200,000+$12,000)/$200,000)=($8,000+$12,000)/$200,000=$20,000/$200,000=0.10 or 10%((\$208,000 - \$200,000 + \$12,000) / \$200,000) = (\$8,000 + \$12,000) / \$200,000 = \$20,000 / \$200,000 = 0.10 \text{ or } 10\%

Next, we adjust for inflation to find the real economic total return:

  • Nominal Return = 10% (0.10)
  • Inflation Rate = 3% (0.03)

Real Return = ((1+0.10)/(1+0.03))−1=(1.10/1.03)−1≈1.06796−1=0.06796 or approximately 6.80%( (1 + 0.10) / (1 + 0.03) ) - 1 = (1.10 / 1.03) - 1 \approx 1.06796 - 1 = 0.06796 \text{ or approximately } 6.80\%

From an economic total return perspective, Sarah's real wealth from the property investment increased by approximately 6.80%. This figure accounts for the erosion of purchasing power due to inflation, giving her a more accurate picture of her economic gain than the nominal 10%. She can use this real return to assess if her investment decisions are truly adding to her long-term wealth.

Practical Applications

Economic total return is a critical metric across various facets of finance and investing:

  • Investment Analysis: Investors and analysts use economic total return to evaluate the true performance of assets like stocks, bonds, or real estate, especially over longer periods where inflation can significantly erode nominal gains. It enables a more accurate comparison of different asset classes.
  • Portfolio Management: Portfolio managers use this concept to ensure their strategies are generating sufficient Real Return to meet clients' long-term financial goals, such as retirement planning or wealth accumulation, which are often stated in real terms.
  • Economic Research: Economists and policymakers utilize measures of economic gains to understand national wealth creation and the effectiveness of fiscal and monetary policies. For instance, the Federal Reserve Bank of St. Louis frequently publishes research on inflation and its impact on the economy, which directly relates to understanding economic total return6.
  • Tax Planning: While tax calculations typically rely on nominal income and Capital Gains, understanding the economic total return can inform investors about the after-tax, after-inflation reality of their gains. The IRS Publication 550, Investment Income and Expenses outlines how various investment incomes are taxed, but it doesn't inherently adjust for inflation in its reporting requirements.
  • Capital Budgeting: Businesses assessing long-term projects often use economic total return considerations, including the impact of inflation on future cash flows and the true cost of capital, to make sound investment decisions.

Limitations and Criticisms

While providing a more insightful view, economic total return also has its limitations. One primary criticism is the difficulty in precisely quantifying all Implicit Costs and opportunity costs. Unlike Explicit Costs which are recorded transactions, implicit costs are often subjective and vary based on individual or organizational alternatives. For example, accurately determining the "best alternative use" of capital for every investment decision can be challenging and is often an estimation.

Furthermore, forecasting future Inflation rates for long-term economic total return projections can be imprecise. Inflation rates are influenced by numerous macroeconomic factors and can be volatile, making long-term predictions prone to error. Relying too heavily on these forecasts for investment decisions can lead to flawed expectations.

Another point of contention can arise in short-term performance analysis. Economic total return is often more meaningful over longer investment horizons, where the cumulative effects of inflation and compounding are more pronounced. For very short periods, the adjustments for inflation or opportunity costs might seem negligible or even distort the immediate operational Profitability picture. Investors must understand that no single metric provides a complete view, and economic total return should be used in conjunction with other Performance Measurement tools.

Economic Total Return vs. Accounting Profit

The distinction between economic total return and Accounting Profit is fundamental in financial analysis. Accounting profit, often referred to as net income, is calculated by subtracting only Explicit Costs (e.g., wages, rent, raw materials, depreciation) from total revenue, as recorded on a company's Financial Statements. It represents the historical, tangible monetary gain of a business and is primarily used for financial reporting, tax purposes, and external stakeholder communication4, 5.

Economic total return, on the other hand, takes a broader view by incorporating both explicit and Implicit Costs, particularly the Opportunity Cost of capital3. While accounting profit might show a positive gain, the economic total return considers whether that gain is truly superior to what could have been earned by investing the same capital in the next best alternative with similar risk1, 2. Additionally, economic total return implicitly considers the erosion of purchasing power due to inflation, which accounting profit does not explicitly factor in. Thus, a venture might show a healthy accounting profit but a meager or even negative economic total return if it fails to beat inflation or alternative investment opportunities. The aim of economic total return is to measure the true increase in wealth or welfare, whereas accounting profit focuses on reported financial performance.

FAQs

What is the core difference between "economic total return" and "total return"?
"Total return" generally refers to the sum of capital appreciation and income (like dividends or interest) over a period, expressed in nominal terms. "Economic total return" takes this further by adjusting for the impact of Inflation and considering the Opportunity Cost of the capital invested. It aims to measure the real increase in purchasing power.

Why is inflation adjustment important for economic total return?
Inflation erodes the purchasing power of money over time. Without adjusting for inflation, a nominal total return might appear positive, but in reality, your money buys less than it did before. Adjusting for inflation gives you the Real Return, which is crucial for assessing true wealth growth.

Does economic total return apply only to businesses, or also to individual investments?
While the concepts of economic profit are often discussed in business contexts, the principle of economic total return applies equally to individual investments. An individual investor holding a stock or bond also faces inflation and has alternative investment opportunities, making the economic perspective relevant for evaluating the true success of their Investment Portfolio.

Is economic total return the same as Return on Investment (ROI)?
Return on Investment (ROI) is a performance measure that evaluates the efficiency of an investment by comparing its gain relative to its cost. While both are performance metrics, ROI is typically a simpler calculation that often doesn't explicitly factor in inflation or comprehensive opportunity costs, focusing more on the direct monetary gain. Economic total return offers a more nuanced, real-world perspective on wealth creation.

How do you determine the "opportunity cost" component in economic total return?
Determining the Opportunity Cost involves identifying the return that could have been achieved from the next best alternative investment with a similar level of risk. This is often subjective and can be challenging to quantify precisely. For practical purposes, it might be estimated based on market benchmarks or the expected return from a diversified portfolio.