There are different formulas for analyzing results.
There’s something satisfying about investing your money to earn more money. Part of that sense of accomplishment probably comes from knowing that you don’t always have to keep your shoulder to the grindstone to get ahead.
But you can’t just sit back and let things happen.
You have to stay alert to the kind of progress you’re actually making toward your financial goals. You can measure the results provided by your investments in two ways, by figuring yield and return.
Yield and return formulas
Yield is what you collect in income on an investment, expressed as a percentage of the amount you spent for your investment. For example, the $50 annual interest payment you get on a bond you bought for $1,000 is a 5% yield.
$ 50 Interest or dividends ÷ $ 1,000 Amount you invested = 5% Yield
Return, or more precisely total return, is the amount your investment increases or decreases in value, plus any income you receive. For example, if you earn $150 on a bond and can sell it for $1,010 instead of the $1,000 you paid for it, your total return is $160 ($150 interest + $10 increase in value = $160).
$ 1,010 Sale price – $ 1,000 Investment = $ 10 Increase in value
$ 10 Increase in value + $ 150 Income from investment = $ 160 Total return
Annual Percent Return
$ 160 Total return ÷ $ 1,000 Amount you invested = 16% Percent return
$ 16% Percent return ÷ $ 3 Number of years = 5.3% Annual percent return
The reason you’re interested in percent return is that the information can help you evaluate whether to keep certain investments in your portfolio or replace them. For example, if the percent return that a large-company mutual fund provides over several years is substantially below the benchmark, or average level of performance, for its category, you may want to move your assets into a similar fund with a better record.
When you own individual investments and are not reinvesting your dividends or interest, calculating percent return can be quite simple, as the illustration here shows. You divide the total return, or income plus increase or decrease in value, by the amount you invested. Then, to find the average annual percent return, you divide the result by the number of years you’ve held the investment.
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If your earnings are being reinvested, the calculation is more complicated because each reinvestment increases your cost basis, or investment amount. If you simply divided total return by your original investment, the result would be too high.
The good news, though, is that retail mutual funds regularly calculate their percent return, including reinvested earnings minus expenses, over a number of periods. While the actual percent return on your account will vary slightly from the numbers the fund reports, based in part on when you bought shares, the results are close enough to provide the information you need.
Current yield on a fixed-income investment, such as a bond, is the amount you’re earning in relation to the current price rather than the amount you invested. It’s a useful number for valuing your investments in the current market.
When return is real?
In figuring return on your investment, there’s another factor you have to take into account — inflation, or the decreasing value of money over time.
Because inflation is persistent, it gradually erodes your buying power. That means you need more income each year simply to maintain the same standard of living you’ve been enjoying. And the longer into the future you are trying to anticipate the income you’ll need, the more you have to be concerned about inflation.
Real return is the return an investment is currently producing minus the current inflation rate. For example, if one of the stock funds in your portfolio reports a one-year return of 8% and inflation is at 3% that year, the real return on your investment is 5% (8% return – 3% inflation = 5% real return). Another way to look at real return is that it’s the portion of your return that matters because it measures the rate at which you’re staying ahead of inflation.
8% Total return – 3% Inflation rate = 5% Real return
The importance of real return emphasizes why you may not want to concentrate too heavily on fixed-income investments in your retirement portfolio. Since the average return on fixed-income investments is already less than the return on equities, inflation has a proportionally greater impact on the real return they provide.
Realized vs unrealized gains
While your actual return on an investment isn’t final until you sell the investment and figure out where you stand, you can keep a running tally of reinvested earnings and any increases or decreases in value by checking your current account value. Remember, though, not to confuse the contributions you’re adding to your account with return that the investment is generating. If your increased value is equal to the contributions you’ve added, your investment isn’t providing a positive return.
Gains in the value of an investment that exist on paper — as opposed to gains in your pocket or your bank account — are unrealized gains. When you sell, your gains, if any, become realized. Realizing a gain means an investment can no longer increase in value, but it also ends the risk that the investment may lose value. You can also have unrealized losses, especially in the short term. And if you sell when an investment is worth less than you paid for it, you realize a loss.
While there’s no ideal investment return, obviously the higher your return over an extended period of time, the more your retirement savings account can grow. One approach is aiming for an 6% overall annual return. You can consider the years you do better as icing on the cake. On the other hand, too many years when your return is lower may be cause for concern: If your average annual return is 3% instead of 6% while you’re accumulating savings, your retirement fund probably won’t provide the income you need.
Understanding The Yield And Return Of Your 401k by Inna Rosputnia
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