Return

What Is Return?

Return, in finance, represents the gain or loss on an investment over a specified period. It is a fundamental concept within Investment Performance and Financial Metrics, indicating the effectiveness of an investment or strategy. Return is typically expressed as a percentage of the initial capital invested, providing a standardized measure to compare different opportunities. A positive return signifies a profit, while a negative return indicates a loss. Understanding return is crucial for investors assessing the performance of individual assets or an entire portfolio.

History and Origin

While the basic concept of gaining more than what was initially put in has existed throughout trade history, the formalization of "Return on Investment" (ROI) as a key financial metric can be largely attributed to F. Donaldson Brown at DuPont in the early 20th century. As an administrative analyst, Brown developed a formula in 1914 to monitor business performance by combining earnings, working capital, and investments in plants and property into a single measure he termed "return on investment." This methodology, later known as the DuPont Model, became a widely adopted standard in business schools and corporations for evaluating financial health and guiding capital allocation decisions. The concept evolved further, influencing how major corporations like General Motors approached pricing strategies to achieve target returns.⁴

Key Takeaways

• Return measures the financial gain or loss on an investment over a period, typically expressed as a percentage.
• It is a core metric for evaluating the performance of individual assets or an entire investment portfolio.
• Return can be influenced by various factors, including price changes, income generated, and market conditions.
• Different types of return exist (e.g., total return, annualized return) depending on what components are included and the timeframe considered.
• While past returns can provide insights, they do not guarantee future performance due to inherent market risk.

Formula and Calculation

The most common way to calculate total return is:

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 beginning of the period.
• Income: Any income generated by the investment during the period, such as dividends, interest payments, or rental income.

For example, if an asset was purchased for $100, is now worth $110, and paid $2 in dividends, the total return would be:

Interpreting the Return

Interpreting return requires context. A 10% return might be excellent in a bear market but mediocre in a strong bull market. Investors often compare an investment's return against a relevant benchmark, such as a stock market index, or against the average return of similar investments. It is also essential to consider the impact of inflation when evaluating returns, as nominal returns do not account for the erosion of purchasing power. The "real return," which adjusts for inflation, provides a more accurate picture of an investment's growth in terms of purchasing power. Studies, such as those documenting the historical returns of the global multi-asset market portfolio, often provide context for long-term investment performance across various asset classes.³

Hypothetical Example

Consider an investor who purchased 100 shares of Company ABC at $50 per share on January 1st, for a total initial investment of $5,000. Over the year, Company ABC pays a total of $1 per share in dividends. On December 31st, the shares are trading at $55 per share.

1. Beginning Value: 100 shares * $50/share = $5,000
2. Ending Value: 100 shares * $55/share = $5,500
3. Income (Dividends): 100 shares * $1/share = $100

Using the total return formula:

This hypothetical investment yielded a 12% return for the year, demonstrating the gain from both capital appreciation and income generation.

Practical Applications

Return is a cornerstone in various financial disciplines. In portfolio management, analysts use return calculations to evaluate the success of different investment strategies and to inform decisions regarding diversification and asset allocation. Investment funds and financial advisors regularly report historical returns to prospective and current clients, often showing performance over 1-year, 5-year, and 10-year periods. Regulators, such as the U.S. Securities and Exchange Commission (SEC), establish strict guidelines for how investment performance, including various measures of return, must be presented in advertisements and marketing materials to ensure transparency and prevent misleading claims. The SEC's Marketing Rule provides guidance on presenting performance metrics, requiring disclosures for "extracted performance" and generally mandating that gross performance be accompanied by net performance.² For businesses, return on investment (ROI) is a key metric for evaluating the profitability of projects, marketing campaigns, or new product lines.

Limitations and Criticisms

While essential, relying solely on return figures has limitations. One significant critique is that historical return does not guarantee future results. Past performance reflects specific market conditions, economic cycles, and other factors that may not repeat. Furthermore, reported security returns often differ from the actual returns experienced by investors. Investor behavior, such as the timing of capital flows into and out of investments, can lead to actual investor returns being systematically lower than theoretical "buy-and-hold" returns due to suboptimal buying and selling decisions.¹ For instance, investors might buy after significant gains and sell after losses, thereby eroding their overall return. Additionally, return calculations may not always account for all costs, such as trading commissions, taxes, or the impact of liquidity constraints, which can affect the true net return to an investor. The impact of volatility on returns also needs careful consideration; a high average return might hide periods of significant downturns.

Return vs. Profit

While often used interchangeably, "return" and "profit" have distinct meanings in finance. Profit generally refers to the absolute monetary gain from a transaction or business activity, calculated as revenue minus expenses. For example, if a product is bought for $10 and sold for $15, the profit is $5.

Return, on the other hand, expresses this gain as a percentage relative to the initial investment. Using the same example, a $5 profit on a $10 investment represents a 50% return ($5/$10). Return provides a standardized measure of efficiency and effectiveness, allowing for comparison across different investments regardless of their absolute size. Profit indicates the amount of money earned, while return indicates how efficiently that money was earned.

FAQs

What is a good rate of return?

A "good" rate of return is relative and depends on various factors, including the type of investment, the associated risk, the prevailing market conditions, and your personal financial goals. For instance, a 5% annual return on a low-risk bond might be considered good, while the same return on a high-growth stock could be seen as underwhelming. Comparing an investment's return to a relevant benchmark or the rate of inflation provides essential context.

How is return different from yield?

Return refers to the total percentage gain or loss on an investment, encompassing both price appreciation (or depreciation) and any income generated (like dividends or interest). Yield, however, typically refers only to the income component of an investment, expressed as a percentage of its current price or face value. For example, a stock might have a 2% dividend yield, but its total return could be much higher (or lower) if its share price changes significantly.

Does return account for compounding?

Yes, when calculating returns over multiple periods, the concept of compounding is crucial. Compound returns reflect the growth of an investment over time, where the earnings from one period are reinvested to generate further earnings in subsequent periods. For instance, an annualized return often assumes the reinvestment of gains. This means that a return calculation over several years naturally incorporates the effect of compounding.

Can historical returns predict future performance?

No, historical returns cannot predict or guarantee future performance. While analyzing past performance can offer insights into an investment's typical behavior under certain conditions, financial markets are dynamic and influenced by numerous unpredictable factors. Disclosures often explicitly state that "past performance is not indicative of future results" to manage investor expectations regarding potential returns.