Return Characteristics of Equity Securities

The two main sources of an equity security's total return are:

• Capital gains from price appreciation
• Dividend income

The total return on non-dividend paying stocks only consists of capital gains.

Investors in depository receipts and foreign shares also incur foreign exchange gains (or losses).

Another source of return arises from the compounding effects of reinvested dividends.

Measures of Returns

1. Holding period return
2. Arithmetic or mean return
3. Geometric mean return
4. Money-weighted return
5. Annualised return
6. Return on a portfolio 
7. Gross versus Net Returns
8. Pre-Tax versus After-Tax Nominal Returns
9. Real versus Nominal Returns
10. Leveraged Return

Dividend - An Easy Pill to Swallow

On the first trading day of 2016, the stock of a company XYZ, sold for $33.66 per share, just 1.6% higher than its price exactly 1 year earlier ($33.16).

Though it might seem that 2016 was a poor year for company XYZ's shareholders, the stock paid dividends during the year totalling $1.52 and those dividends raised the total return on company XYZ in 2016 to 6.2%.

Why Return is Important

An asset's return is a key variable in the investment decision because it indicates how rapidly an investor can build wealth.

Naturally, because most people prefer to have more wealth rather than less, they prefer investments that offer high returns rather than low returns if all else is equal.

However, the returns on most investments are uncertain, so how do investors distinguish assets that offer high returns from those likely to produce low returns?

One way to make this kind of assessment is to examine the returns that different types of investments have produced in the past.


Historical Performance

Most people recognize that future performance is not guaranteed by past performance, but past data often provide a meaningful basis for future expectations.

A common practice in the investment world is to look closely at the historical record when formulating expectations about the future.

The relationship of risk and potential reward in stock investing is often misunderstood in shaping an investment strategy.

There is no investing in stocks without risk and there is no return without risk.

If you are adverse to the idea of taking any amount of risk, then stocks are not for you.

It will be more difficult (but not impossible) for you to reach your financial goals without investing in stocks.


Understanding Risk

Risk is the potential for your investment to lose money, for a variety of reasons - meaning your stock's price will fall below what you paid for it.

No one wants to lose money on an investment, but there's a good chance you will if you invest in stocks.

The rule of thumb is "the higher the risk, the higher the potential return, and the less likely it will achieve the higher return."

Buying a stock that is risky doesn't mean you will lose money and it doesn't mean it will achieve a 25% gain in one year. However, both outcomes are possible.

How do you know what the risk is and how do you determine what the potential reward (stock price gain) should be?


Measuring risk against reward

When you evaluate stocks as potential investment candidates, you should come up with an idea of what the risks are and how much of a potential price gain would make the risks acceptable.

Calculating risk and potential reward is as much an art as it is a science.

You need to understand the principle of risk and reward to make an educated investment as opposed to a guess.

The most common type of risk is the danger your investment will lose money.

You can make investments that guarantee you won't lose money, but you will give up most of the opportunity to earn a return in exchange.

When you calculate the effects of inflation and the taxes you pay on the earnings, your investment may return very little in real growth.


Will I achieve my financial goals?

If you can't accept much risk in your investments, then you will earn a lower return.

To compensate for the lower anticipated return, you must increase the amount invested and the length of time it is invested.

Many investors find that a modest amount of risk in their portfolio is an acceptable way to increase the potential of achieving their financial goals.

By diversifying their portfolio with investments of various degrees of risk, they hope to take advantage of a rising market and protect themselves from dramatic losses in a down market.

The elements that determine whether you can achieve your investment goals are the following:
1. Amount invested
2. Length of time invested.
3. Rate of return or growth
4. Fewer fees, taxes, and inflation.


Minimize risk - Maximize reward

The MOST SUCCESSFUL INVESTMENT is one that gives you the most return for the least amount of risk.

Every investor needs to find his or her comfort level with risk and construct an investment strategy around that level.

A portfolio that carries a significant degree of risk may have the potential for outstanding returns, but it also may fail dramatically.

Your comfort level with risk should pass the "good night's sleep" test, which means you should not worry about the amount of risk in your portfolio so much as to lose sleep over it.

There is no "right or wrong" amount of risk - it is a very personal decision for each investor.

However, young investors can afford higher risk than older investors can because young investors have more time to recover if disaster strikes.

If you are 5 years away from retirement, you don't want to be taking extraordinary risks with your nest-egg, because you will have little time left to recover from a significant loss.

Of course, a too-conservative approach may mean you don't achieve your financial goals.

Stocks and Bonds: Risk vs. Return

Take a good look at this chart.

It is a portfolio consisting of only 2 assets:  stock and bond.  

Here are some interesting points:  

1.  100% in Stock
This portfolio has the highest risk and also probability of the highest return.

2.  100% in Bond
This portfolio has low risk (NOTE: NOT THE LOWEST) and has lower return.

3.  50% in Stock and 50% in Bond
This portfolio has the same risk as and has higher return than the portfolio that is 100% in Bond.

4.  25% in Stock and 75% in Bond
This portfolio has the lowest risk and has higher return than the portfolio that is 100% in Bond.


(You may assume that holding cash giving an interest rate of 3% is the equivalent of holding a bond with a coupon rate of 3%.)


Conclusion:

Holding 100% in bond carries the same risk as holding 50% in stock and 50% in bond.  However, the probability of a higher return for the same risk should make investors favour holding 50% in stock and 50% in bondthan to hold 100% in bond.

For those who are very risk averse, for example in the present falling market, the lowest risk is the portfolio that is 25% stock and 75% bond, and not the portfolio that is 100% in bond.  Moreover, the portfolio that is 25% stock and 75% bond, offers a probability of higher return for lower risk, that the portfolio with 100% in bond.

How to figure your portfolio's return

Q: How can individual investors calculate the rate of return on their portfolios if they have deposited or withdrawn money from the account?

A: I'm always intrigued when people do things with their investments they'd never do with their money in normal life.

Would you order a dish from a restaurant menu without knowing the price ahead of time? Would you buy a non-refundable airline ticket without knowing the fare? While there may be some exceptions, the answer will usually be no.

But investors keep buying stocks, bonds and mutual funds and have no idea what they're paying or, more important, getting in return. And they may be paying dearly either with large mutual fund fees or indirectly with lackluster performance.

Worse yet, they might be fixated on their one winning stock while ignoring the five dogs that are killing their portfolio.

Are you one of these people? You are if you don't know how to calculate the return of your portfolio. You'd be surprised how many people don't. The briefly famous Beardstown Ladies investment club thought they were brilliant investors until it was discovered they were not measuring their returns properly (they counted deposits to the account as investment returns).

Many brokers don't help. Few of them bother to provide rates of return for their customers' portfolios. The cynic in me suspects that if many active traders knew what their real returns were, they'd probably quit trading so much. To the credit of major mutual fund companies, most of them do calculate your performance data.

Well, it all gets cleared up right now. I'll show you how to do this yourself, using 2005. To get started, you'll need:

1. The balance of your portfolio on Dec. 31, 2004, available on your statements.

2. The portfolio balance on Dec. 30, 2005.

3. The dates and amounts of any deposits or withdrawals made during the year.

4. Unless you're a math genius, you'll need a financial calculator or Microsoft Excel.

Let's say your portfolio was worth $10,000 on Dec. 31, 2004. During the year, you deposited $1,000 on March 30, withdrew $500 June 30, deposited another $1,000 Sept. 30 and the portfolio ended the year worth $12,000.

Someone who didn't account for the deposits and withdrawals would assume they did well last year. After all, the portfolio gained 20% in value, not including the value of the deposits and withdrawals.

But let's do this correctly. We'll first do the problem assuming you have a Hewlett-Packard 12C financial calculator, a popular calculator handy for all investors. Incidentally, the calculator is celebrating its 25th anniversary. You can read more about it here.

Keep in mind that each number described above is actually a cash flow. We can plot it this way:

Initial cash flow: minus $10,000. We show this as a negative number because it's theoretically money coming out of your pocket to invest.

Cash flow 1: minus $1,000 — again, a negative number because the money is coming out of your pocket.

Cash flow 2: plus $500. This is positive number because the cash is coming into your pocket.

Cash flow 3: minus $1,000. Negative, see above.

Cash flow 4: plus $12,000. This is the money theoretically coming into your pocket from the investment.

The HP 12C makes this easy to calculate. Here are the keystrokes (note the "CHS" key makes the number negative):

Step 1: 10,000 CHS [g] Cf0

Step 2: 1,000 CHS [g] Cfj

Step 3: 500 [g] Cfj

Step 4: 1000 CHS [g] cfj

Step 5: 12000

Now that you've entered everything, all you have to do is hit the [f] IRR key, and the calculator does the rest. The HP12C will show you that the quarterly return on your portfolio is 1.14%. All you have to do is annualize that quarterly return. To do that, divide 1.14 by 100, add 1, take the sum to the fourth power, subtract 1 and then multiply by 100. You then derive an annualized return of 4.639%.

You might be proud of yourself until you realize that last year, the Standard & Poor's 500 index returned 4.9%, says Ibbotson Associates. In other words, you underperformed a basket of stocks that a monkey could have bought and held in an index fund. And that doesn't even include any taxes you may have paid if you sold any of the shares for a capital gain.

What if you don't have an HP 12C? You can do the same thing in Microsoft Excel. Below is what you'd type into the appropriate cells

Cell A1: -10,000

Cell A2: -1,000

Cell A3: 500

Cell A4: -1000

Cell A5: 12,000

Cell A6: =IRR(A1:A5)

Cell A7:=((((A6/100)+1)^4))-1*100

And you get the same answer in cell A7 that you got when using the HP 12C if you format the cells for "number" to four decimal places. Otherwise, Excel will round things off.

If all this seems like too much work, don't give up. Not knowing your portfolio return is like driving on the freeway blindfolded. Another option is to buy a software program that does the calculations for you.

One piece of software I've used that does this quite well is the BetterInvesting Portfolio Manager. This software program allows you to do enter each transaction into a checkbook-like register and it calculates your return with great precision. It's not cheap, but you can learn about the software and download a free trial here.

Matt Krantz is a financial markets reporter at USA TODAY. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt atmkrantz@usatoday.com.

Posted 2/27/2006 12:01 AM ET http://www.usatoday.com/money/perfi/columnist/krantz/2006-02-27-portfolio-return_x.htm Calculate your portfolio return here: Detailed version:   CALCULATE YOUR PORTFOLIO'S RETURN Simplified version:  Portfolio Rate of Return – Calculator

For most investments the amount of profit earned can be known only after maturity or sale.

While security analysts attempt to determine with precision the risk and return of investments, events alone accomplish that.

For most investments the amount of profit earned can be known only after maturity or sale. 

• Only for the safest of investments, is return knowable at the time of  purchase:  a one-year 6 percent T-bill returns 6 percent at the end of one year.  
• For riskier investments the outcome must be known before the return can be calculated.  If you buy one hundred shares of XYZ Corporation, for example, your return depends almost entirely on the price at which it is trading when you sell.  Only then can the return be calculated.

Getting real about returns

I have added the link below to highlight that a fund may outperforms the market in the long run and yet many of the investors may lose money due to various reasons. "After he retired at the age of 47, Lynch reported that, wonder of wonders, most of the investors in the Fidelity Magellan Fund lost money during his stellar run! They had bought into the fund when the market was doing well. Obviously, they paid a high price at that time as the market was peaking. Unfortunately, they panicked and sold out during the times the fund went south."  Imagine that: the investors were actually holding a winner and yet, they lost money!

Getting real about returns

Real Returns from Equities, Bonds and Bills (1900 to 2008)

Investing in shares? Plan for the very long-term

Read more: http://www.dailymail.co.uk/money/article-1145151/INVESTMENT-EXTRA-Investing-shares-Plan-long-term.html#ixzz0uKmYK8FD

Different investments offer different levels of potential return and market risk.

Large-cap stocks are represented by the total returns of the S&P 500 index. Midcap stocks are represented by a composite of the CRSP 3rd-5th deciles and the S&P 400 index. Small-cap stocks are represented by a composite of the CRSP 6th-10th deciles and the S&P 600 index. Foreign stocks are represented by the total returns of the MSCI EAFE index. Bonds are represented by the total returns of the Barclays U.S. Aggregate Bond index. Cash is represented by a composite of yields on 3-month Treasury bills and the Barclays 3-Month Treasury Bills index.
Based on average 12-month returns from 1980-2009. (CS000168)

Different investments offer different levels of potential return and market risk. International investors are subject to higher taxation and currency risk, as well as less liquidity, compared with domestic investors. Small-cap and midcap stocks are generally subject to greater price fluctuations than large-cap stocks. Unlike stocks and corporate bonds, government T-bills are guaranteed as to principal and interest, although funds that invest in them are not. Past performance is not a guarantee of future results.

http://fc.standardandpoors.com/srl/srl_v35/library_article.jsp?tid=0099

Shareholder value and Total Shareholder Return (TSR)

While profits are owned by the shareholders, they are not necessarily paid out as dividends, and may be retained  in the business to fund its growth.  For instance, biotech companies often do not pay a dividend to their shareholders.

In reality the return a shareholder sees is the increase in the share price over time, and the cash dividends received from the company.  Typically this TSR is normally calculated over the past 3 to 5 years.

This can be further complicated by using discounted cash flow to reflect the fact that money earned in the future is worth less than its worth today.  TSR calculated in this way is used by a number of companies, but there is little evidence that the stock markets have adopted this as a measure of shareholder value over more conventional measures such as the share price and profit performance.

A drawback of looking at TSR is that we are either

• looking at historic performance over the last 3 to 5 years (which is not necessarily an indication of future trends) or 
• we are estimating future values (say, for the share price) which are not always borne out in practice.

Safe and Risky Investments

Safe and Risky Investments

Joe Conservative hates risk and is terrified of the prospects of losing money. He is strictly a bank CD man, being highly suspicious of the stock market. His girlfriend, Rita Riskaverse, doesn’t like risk either, but she studied investments in college and knows something about the relationship between risk and return.

Joe and Rita eventually get married but decide it makes sense for them to handle their investments individually. Joe puts $100,000 in a bank certificate of deposit earning 6% annually, while Rita spreads her $100,000 equally across five stocks, putting $20,000 in each one.

Twenty years later the two lovebirds decide to do some joint financial planning, which requires them to disclose the performance of their personal investment accounts.

Rita does some calculations on the performance of her five stocks. She tells Joe “I had one stock go bankrupt, two that earned less than your 6% from the bank, one that earned 8%, and one that earned 12%.”

Joe responds, “I told you the stock market was too risky. You should have listened to me.”

Suppressing a smirk, Rita shows Joe the data below.

----
Joes’s Bank CD:
$100,000 x (1.06)^20 = $320,714

Rita’s Stocks:
Stock A: worthless $0
Stock B: $20,000 x (1.03)^20 = $36,122
Stock C: $20,000 x (1.05)^20 = $53,066
Stock D: $20,000 x (1.08)^20 = $93,219
Stock E: $20,000 x (1.12)^20 = $192,926
Total = $375,373
----

Joe can’t believe it. Rita had one stock go under, two that were below-average performers, and two that did okay but certainly didn’t set the world on fire. It seems like luck to him that her portfolio is worth more than his – although he can’t put his finger on what was lucky. It just doesn’t seem fair.

Understanding Risk and Return

Understanding Risk and Return

To get profit without risk, experience without danger, and reward without work, is as impossible as it is to live without being born. – A.P. Gouthev

Two key concepts provide the foundation for the field of finance.
1. A dollar today is worth more than a dollar tomorrow – this is the time value of money.
2. A safe dollar is worth more than a risk dollar.
The trade-off between risk and return is the principal theme in the investment decision.

RISK AVERSE: Most people are risk averse. This does not mean, however, they will not take a risk. It means they take a risk only when they expect to be rewarded for taking it. People have different degrees of risk aversion; some are more willing to take a chance than are others.

RISK NEUTRAL: Someone who is indifferent to risk is risk neutral.

RISK SEEKER: Someone who actively seeks out risky situations (a gambler) is a risk seeker.

• For small amounts of money, most people enjoy the thrill of a long-shot wager.
• For more significant sums, though, the tendency to risk aversion is nearly universal.

RETURN: People invest because they hope to get a return from their investment. Return is the good stuff that makes people feel better or improves their standard of living.

RISK: Risk is the bad stuff a risk averse person seeks to avoid. It is a fact of investment life and is unavoidable for anyone who seeks more than a trivial rate of return. Note that risk is a “four letter word.”

Risk may be unavoidable, it is manageable.

Risk and Return

Sure, you'd like to make a fortune in the markets -- who wouldn't? The first thing you need to understand, before you commit even a dollar to a portfolio or begin surfing investing Websites, is that it's impossible to realize a return on any investment without facing a certain degree of risk.
According to Webster's, risk is the "possibility of loss or injury." In investing, risk is the chance you take that the returns on a particular investment may vary. That's another way of saying that there are no sure things when you're investing.
No matter what you decide to do with your savings and investments, your money will always face some risk. You could stash your dollars under your mattress or in a cookie jar, but then you'd face the risk of losing it all if your house burned possibly less dollars in real terms than when you started. Investing in stocks, bonds, or mutual funds carries risks of varying degrees.
The second fact you need to face is that in order to receive an increased return from your investment portfolio, you need to accept an increased amount of risk. Keeping your money in a savings account reduces your risk, but it also reduces your potential reward.
While risk in your portfolio may be unavoidable, it is manageable. The riddle of controlling risk and return is that you need to maximize the returns and minimize the risk. When you do this, you ensure that you'll make enough on your investments, with an acceptable amount of risk.

So, what constitutes acceptable risk?
It's different for every person. A good rule of thumb followed by many investors is that you shouldn't wake up in the middle of the night worrying about your portfolio. If your investments are causing you too much anxiety, it's time to reconsider how you're investing, and bail out of those securities that are giving you insomnia in favor of investments that are a little less painful. When you find your own comfort zone, you'll know your personal risk tolerance -- the amount of risk you are willing to tolerate in order to achieve your financial goals.
When it comes to your long-term financial future though, the biggest risk of all may simply be to do nothing. If you don't invest for retirement, or for the college education of your children, or to help meet your personal financial goals, then you're most likely guaranteed a future of just scraping by.

http://finance.yahoo.com/education/begin_investing/article/101171/Risk_and_Return

Returns from Investment

Stock returns

The returns from owning stocks come from 2 sources.

Cash dividends are earnings that are distributed to shareholders. (Unlike bonds, stocks do not guarantee the timing or the amount of dividends).

At any time, they can be increased, decreased or taken away altogether.

The other source of returns is capital gains. This is the main reason people buy stocks.

The value of your stock may rise when the earning prospects of the company are favourable.

And of course, your shares may also lose value if the company performs poorly.


Bond returns

The returns from owning a fixed-income security come in two forms.

There are the fixed interest payments and the final payment of principal at maturity.

Secondly, there is the potential for capital gains when you sell a bond before its maturity at a price higher than when you purchased it.

Imagine a see-saw. The price of a bond rises when the interest rates fall, and there is thus the possibility of a capital gain from a favourable movement in rates. Of course, inversely, a rise in interest rates will produce a loss.


Money market returns

Money market investments maintain a stable value, pay interest and can easily be converted into cash.

Of the three types of investments, money market instruments pay the lowest rate of return.

So why bother with them?

For the same reason that you leave large chunks of your uninvested money in fixed deposit - safety.

When you buy a money market investment, you are pretty sure you will get your money back with some interest.

The chances of losing money - whether from the government or the bank defaulting on its payment or a loss in principal value of the investment - are very low.

When you invest in a money market investment, you are taking very little risk and your expected return should reflect the amount of risk that you have taken.

When is a money market investment appropriate? When you need to use the money in a year or so, and you want to know that the money will be there with few surprises.