Measuring investment returns can get quite confusing due to the number of different ways returns are calculated and presented to investors. It can be challenging for investors to get a sense of comparable returns across investment options and time frames. Fortunately there is a calculation, called total return, that best reflects the economic reality of your investment decisions.
Starting with a definition, total return is a measure of the increase in the investor’s wealth due to both investment income (for example, dividends and interest) and capital gains (both realized and unrealized). From there, the total return can be presented as a holding period return over a specific time frame (monthly, quarterly, annual, or cumulative) or as an annualized return. An annualized return is helpful to compare investment returns over longer time frames.
Total return is often presented with further qualifications to help shed light on an investor’s results. First, the total return is typically presented in nominal terms unadjusted for inflation. A real return measures the investor’s change in wealth after accounting for the effects of inflation. An example illustrates the difference. A bond with a 6 percent yield and an economy with a 2 percent inflation rate earns a real return of 4 percent. The distinction is important to communicate to an investor during periods of rising price levels for goods and services. Inflation erodes the purchasing power of the investor’s wealth. A second qualification is gross returns and returns net of investment management fees. This qualification is not relevant for individual securities but mutual funds and exchange traded funds have fees that get netted against the gross returns of the investment product. Returns are often presented gross of fees to make investment options easier to compare considering each product will have a different fee structure. That said, the investor receives the net of fee return so be careful not to confuse the two.
Getting to the proper annualized return when faced with a series of investment return data can be complex, too. A simple average of annual returns does not reflect the economic reality of the investor. The proper calculation to get there is the geometric average. This number is calculated by multiplying a series of numbers and taking the nth root of the product, where n is the number of items in the series. A quick example will illustrate. Consider a three year investment that returned +20% year one, -10% year two and +5% year three. A simple average would yield a return of 5%. However, this overstates the economic reality. Using the geometric return calculation, the product of these returns is (1.20)*(0.90)*(1.05) = 1.134. The nth root, in this case three periods, yields an annualized return stream of 4.28%.
There is a lot to consider for an investor but it starts with a fairly simple calculation. From there the industry can present information a number of ways to incorporate time, inflation, and fees. The bottom line is to make sure you are not comparing apples and oranges and keep in mind the economic reality.
Brian Summers is a Trust Officer and Portfolio Manager in the Michigan City, Indiana office of Horizon Bank with more than 15 years of investment experience. He also holds the Chartered Financial Analyst (CFA) and Chartered Alternative Investment Analyst (CAIA) designations.