What Is Total Return?
Total return, when measuring performance, is the actual rate of return of an investment or a pool of investments over a given evaluation period. Total return includes interest, capital gains, dividends, and distributions realized over a period. Total return accounts for two categories of return: income including interest paid by fixed-income investments, distributions, or dividends and capital appreciation, representing the change in the market price of an asset.
Key Takeaways:
- Total return is the actual rate of return of an investment or a pool of investments over a period.
- Total return includes interest, capital gains, dividends, and realized distributions.
- Total return is expressed as a percentage of the amount invested.
- Total return is a strong measure of an investment’s overall performance.
Understanding Total Return
Total return is the amount of value an investor earns from a security over a specific period, typically one year when all distributions are reinvested. The total return is expressed as a percentage of the amount invested. For example, a total return of 20% means the security increased by 20% of its original value due to a price increase, distribution of dividends (if a stock), coupons (if a bond), or capital gains (if a fund). It is a strong measure of an investment’s overall performance.
Significance of Total Return
Some of the best dividend stocks have low growth potential and produce small capital gains. Basing an investment’s return on capital gains alone does not take into consideration price increases or other methods of growing the stock’s value. For example, an investor buys shares of Company B, and the share price increases 24.5% in one year. The investor gains 24.5% from the price change alone. Since Company B also paid a dividend during the year, adding in the stock’s yield of 4.1% to the price change, the combined return is 28.6%.
The investor may wish to calculate dividend-adjusted return. This figure considers both the stock price appreciation and its dividends. The dividend-adjusted return provides a more accurate valuation of a stock's return.
Total return determines an investment’s true growth over time. It is important to evaluate the big picture and not just one return metric when determining an increase in value.
Total return is used when analyzing a company’s historical performance. Calculating expected future returns puts reasonable expectations on an investor’s investments and helps plan for retirement or other needs.
Average Annual Total Returns
When analyzing mutual fund performance, investors should analyze their average annual total returns for different periods. Comparing returns to a benchmark indicates how the fund has performed, relative to an index. When analyzing average annual total returns, it's important to remember:
- The numbers almost always reflect the reinvestment of dividends and capital gains distributions.
- Effects of sales charges may or may not be included. However, this information is disclosed with return numbers.
Example of Total Return
An investor buys 100 shares of Stock A at $20 per share for an initial value of $2,000. Stock A pays a 5% dividend the investor reinvests, buying five additional shares. After one year, the share price rises to $22.
To calculate the investment's total return, the investor divides the total investment gains (105 shares x $22 per share = $2,310 current value - $2,000 initial value = $310 total gains) by the initial value of the investment ($2,000) and multiplies by 100 to convert the answer to a percentage ($310 / $2,000 x 100 = 15.5%). The investor's total return is 15.5%.
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Total Return Defined: The article accurately describes total return as the actual rate of return of an investment or a portfolio over a specific period. It encompasses various components such as interest, capital gains, dividends, and distributions. This comprehensive measure provides investors with a holistic view of the performance of their investments.
Components of Total Return: The breakdown of total return into income (interest, dividends, and distributions) and capital appreciation is crucial. This distinction recognizes the dual nature of returns, highlighting not only the yield generated but also the capital growth resulting from changes in the market price of an asset.
Expression as a Percentage: Expressing total return as a percentage of the amount invested is a fundamental aspect emphasized in the article. This percentage representation makes it easier for investors to compare the performance of different investments on a standardized scale.
Significance of Total Return: The article rightly underscores total return as a robust measure of an investment's overall performance. It goes further to emphasize its importance in assessing the growth of an investment over time, cautioning against relying solely on individual return metrics.
Dividend-Adjusted Return: The concept of dividend-adjusted return is skillfully introduced, illustrating the need to consider both stock price appreciation and dividends. This nuanced approach provides a more accurate evaluation of a stock's return, especially for income-focused investors.
Average Annual Total Returns: The article introduces the concept of average annual total returns, particularly relevant when analyzing mutual fund performance. Emphasizing the importance of comparing returns to a benchmark adds depth to the evaluation process. Additionally, the disclosure of information regarding the reinvestment of dividends and the potential inclusion of sales charges enhances transparency.
Example of Total Return: The practical example involving Stock A effectively demonstrates the calculation of total return. It brings to life the application of the formula, where the investor considers both capital gains and reinvested dividends in determining the overall return percentage.
In conclusion, the article provides a comprehensive overview of total return, catering to both novice and seasoned investors. The inclusion of real-world examples and practical considerations enhances its educational value, making it a valuable resource for anyone seeking a deeper understanding of investment performance metrics.
