Returns

What Are Returns?

Returns represent the gain or loss on an investment over a specified period, expressed as a percentage of the initial cost. They are a fundamental measure within the field of investment performance and are crucial for evaluating the success or failure of financial decisions. Investors typically seek positive returns, indicating an increase in the value of their holdings. Understanding returns is essential for gauging how well a security, a portfolio, or an entire market has performed.

History and Origin

The concept of returns has been central to financial analysis for as long as people have been investing. However, the formal mathematical and theoretical framework for understanding and optimizing returns in the context of risk truly began to develop in the mid-22nd century. A pivotal moment came with Harry Markowitz's seminal paper, "Portfolio Selection," published in 1952. Markowitz's work laid the foundation for Modern Portfolio Theory (MPT), which demonstrated how to construct portfolios that maximize expected returns for a given level of risk or minimize risk for a given expected return. This groundbreaking contribution earned him a share of the Nobel Memorial Prize in Economic Sciences in 1990, recognizing his profound impact on the field of financial economics.⁴

Key Takeaways

• Returns quantify the percentage gain or loss on an investment over a specific period.
• They are a primary metric for assessing investment performance.
• Returns can originate from price appreciation, dividends, interest income, or a combination.
• Real returns account for the eroding effect of inflation, providing a truer picture of purchasing power changes.
• Calculating and interpreting returns is essential for comparing investment opportunities and making informed financial decisions.

Formula and Calculation

The most basic formula for calculating a simple return (or holding period return) is:

Where:

• Current Value: The market value of the investment at the end of the period.
• Initial Cost: The original purchase price or value of the investment at the beginning of the period.
• Income: Any cash flows received from the investment during the period, such as dividends or interest payments.

When returns are calculated over multiple periods, such as annually, they can be compounded to show the total effect of growth. For example, annual returns can be chained together using geometric averaging to provide a more accurate depiction of multi-year performance than simple arithmetic averaging, especially when there's volatility. This is particularly relevant for understanding the long-term impact of compound interest.

Interpreting Returns

Interpreting returns involves more than just looking at the final percentage. It requires considering the time horizon of the investment, the associated risk, and the impact of inflation. A high return over a short period might be less impressive than a moderate return consistently achieved over a long period, especially if the higher return came with significantly greater risk.

To truly assess the success of an investment, returns are often compared to relevant benchmarks or the average returns of similar assets. For instance, comparing the returns of a stock portfolio to the returns of a broad market index like the S&P 500 can indicate whether the investment outperformed or underperformed the general market. Additionally, understanding the source of returns—whether from capital gains or recurring income like dividends—provides insight into the nature of the investment's profitability.

Hypothetical Example

Consider an investor who purchases 100 shares of Company A at an initial cost of $50 per share, for a total initial investment of $5,000. Over one year, Company A pays a dividend of $1 per share, and the stock price rises to $55 per share.

To calculate the return:

1. Initial Cost: $50 * 100 shares = $5,000
2. Current Value: $55 * 100 shares = $5,500
3. Income (Dividends): $1 * 100 shares = $100

Using the formula:

In this hypothetical scenario, the investor earned a 12% return on their investment over the year, demonstrating the combined effect of price appreciation and dividend income.

Practical Applications

Returns are a cornerstone of financial analysis, used across various facets of investing and economic planning:

• Performance Measurement: Investors and financial analysts constantly track returns to evaluate the performance of individual securities, mutual funds, and investment managers.
• Investment Decision-Making: Expected returns are a key factor when making investment decisions, often weighed against the associated risk. For example, an investor might analyze historical yield data for different asset classes when constructing their asset allocation strategy.
• Regulatory Compliance: Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), have strict rules regarding how investment performance and returns are presented in marketing materials to ensure transparency and prevent misleading claims. Recent SEC guidance, for instance, has clarified requirements for presenting gross versus net performance in advertisements.
• ³ Economic Analysis: Economists and policymakers analyze aggregate market returns, such as the S&P 500 total returns, to gauge the health of the economy and understand long-term wealth creation trends.

##² Limitations and Criticisms

While returns are a critical metric, they have limitations:

• Past Performance is Not Indicative of Future Results: This ubiquitous disclaimer highlights that historical returns offer no guarantee of future returns. Market conditions change, and past successes do not inherently predict future ones.
• Risk-Adjusted Returns: A high return achieved with excessive risk might be less desirable than a lower return with less risk. Metrics like the Sharpe ratio attempt to address this by incorporating risk into the return calculation, providing a more holistic view.
• Inflation Erosion: Nominal returns do not account for inflation, which erodes purchasing power. A 5% nominal return when inflation is 3% only provides a 2% real return.
• Efficient Market Hypothesis (EMH) Challenges: The Efficient Market Hypothesis suggests that asset prices already reflect all available information, making it difficult for investors to consistently achieve abnormal returns (i.e., returns exceeding what would be expected given the risk). While influential, the EMH has faced criticism from behavioral finance, which argues that psychological biases can lead to market inefficiencies and opportunities for outperformance. Cri¹tics point to market anomalies or periods of irrational exuberance or panic as evidence against perfect efficiency.

Returns vs. Profit

While "returns" and "profit" are often used interchangeably in general conversation, they have distinct meanings in finance:

Returns focus on the rate of gain relative to the capital invested, allowing for easy comparison across different investment sizes. Profit, on the other hand, measures the total monetary gain from a business activity or specific transaction. An investment could yield a substantial profit in dollar terms but a low percentage return if the initial capital invested was very large. Conversely, a small investment could generate a high percentage return even if the absolute dollar profit is modest.

FAQs

What are good returns for an investment?

What constitutes "good" returns depends heavily on the type of investment, the risk taken, and the investment horizon. For example, typical stock market returns are historically higher than those for bonds or cash, but also carry more volatility. Generally, returns that comfortably beat inflation and a relevant benchmark are considered good.

How do taxes affect returns?

Taxes significantly impact net returns. Capital gains, dividends, and interest income are usually subject to taxation. When evaluating an investment, it is important to consider after-tax returns, as the amount you keep in your pocket is what truly matters for your purchasing power.

What is the difference between nominal and real returns?

Nominal returns are the stated percentage gain or loss without accounting for inflation. Real returns, however, adjust for inflation, providing a more accurate measure of the actual increase or decrease in purchasing power. If your nominal return is 7% and inflation is 3%, your real return is approximately 4%. Understanding real returns is crucial for long-term financial planning.

Can returns be negative?

Yes, returns can absolutely be negative. This is known as a loss. Investments are not guaranteed, and the value of an asset can decrease below its initial cost, resulting in negative returns. Markets experience fluctuations, and investors must be prepared for the possibility of losses, especially in the short term.