When you invest your money, don’t you want to make sure you’re getting a good return on it? Of course Sherlock, you might say! That’s obvious.
That means you want to make as much money as possible from your investments, with as little risk as possible. But how do you know if you’re really making a good return? That’s where evaluating and calculating your investment return comes in. There are a few different ways to do this, and it’s important to understand them so you can make smart decisions about your money.
In this article, we’ll go over the top five ways to evaluate and calculate your investment return. Let’s jump in:
1. Total Return
Total return measures the overall performance of your investment, including any income generated (such as dividends or interest) and any change in the value of the investment (i.e. capital appreciation).
Here is an example of a total return calculation:
Suppose you invest $20,000 in a stock that pays a dividend of $100 per year and increases in value by 10% over the course of a year. At the end of the year, the value of your investment is $22,000, and you have received a dividend of $100.
To calculate the total return on your investment, you would add the increase in the value of your investment ($2,000) to the dividend income ($100) and divide by the original investment amount ($20,000).
This gives a total return of (2,000 + 100) / 20,000 = 10.5%.
This calculation shows that your investment has generated a total return of 10.5% over the course of the year, including both the increase in the value of the investment and the dividend income.
2. Annualized Return
Annualized return is simply the average annual return on your investment over a specific period of time.
Here is an example of an annualized return calculation:
Suppose you invest the same $10,000 and your investment grows to $15,000 over 4 years. This means you earned $5,000 or 50% total return in 4 years.
To calculate the annualized return, the formula is (1 + Total Return % over n periods) ^ (1 / n). In our example, this translates to:
(1 + 0.50) ^ (1/4) = 10.67%
Notice this is less than if you were to divide 50% by 4 because of the compound effect of investing. Annualized return assumes that you reinvest your profit/gains over the 4 years.
3. Internal Rate of Return (IRR)
Internal rate of return (IRR) is a measure of the profitability of an investment, taking into account the timing and size of cash flows. To determine the internal rate of return (IRR), you would need to determine the rate of return that would make the net present value (NPV) of the investment equal to zero.
The NPV is calculated by discounting the cash flows at a given rate and subtracting the initial cash outflow. Or in general, adding all positive cash flow and subtracting all negative cash flow.
- NPV = [- Cash Flow A] + [Cash Flow B / (1 + discount rate)] + [Cash Flow C / (1 + discount rate) ^ 2] + …. + [Cash Flow n /(1 + discount rate) ^ n]
Here is an example of calculating the internal rate of return (IRR) for an investment:
Suppose you invest $6,000 in a project that is expected to generate the following cash flows over the next three years:
- Year 1: $3,000
- Year 2: $2,500
- Year 3: $4,000
If you assume a discount rate of 10%, the NPV of the investment would be:
- NPV = [-$6,000] + ($3,000 / (1 + 0.10)) + ($2,500 / (1 + 0.10)^2) + ($4,000 / (1 + 0.10)^3)
- NPV = (-$6,000) + $2,727.27 + $2,066.12 + $3,005.26
- NPV = $1,798.65
The discount rate is not high enough to make the NPV equal to zero. To find the IRR, you would need to increase the discount rate until the NPV becomes zero. Using a financial calculator, spreadsheet software, or trial and error until you get to zero, you can find that the IRR for this investment is approximately 25.5%. This means that if the investment generates the expected cash flows, the rate of return on the investment would be 25.5%.
4. Risk-Adjusted Return
Risk-adjusted return measures the return on an investment relative to the level of risk taken on. An example of a risk-adjusted return is the Sharpe ratio. It compares the return on investment to the volatility of that investment, as measured by standard deviation.
Here is an example of calculating risk-adjusted return:
Suppose you are considering two investments:
1st Investment: A high-risk stock with an expected return of 20% and a standard deviation of 30%.
2nd Investment: A low-risk bond with an expected return of 8% and a standard deviation of 10%.
To compare the risk-adjusted return of these two investments, you can use the Sharpe ratio for example. It is calculated as the excess return (return minus the risk-free rate) divided by the standard deviation.
If the risk-free rate is 2%, the Sharpe ratios for these two investments would be:
- 1st Investment: (20% – 2%) / 30% = 0.53
- 2nd Investment: (8% – 2%) / 10% = 0.60
The higher the Sharpe ratio, the better the risk-adjusted return. In this case, the 2nd Investment has a higher Sharpe ratio, indicating that it has a better risk-adjusted return than the 1st Investment. This means that, despite having a lower expected return or 10%, the 2nd Investment offers a better return per unit of risk taken on.
The lesson here is that a high return shouldn’t be looked at on its own. Considering the risk of the investment is important as well.
5. Comparing Your Investment Return to a Benchmark
Comparison to a benchmark involves comparing the return on your investment to a relevant benchmark, such as the S&P 500 index for stocks or the Barclays Aggregate Bond Index for bonds. The idea is that your investment should return at least the same or more than the index.
Here is an example of comparing your investment return to a benchmark:
Let’s say you have a portfolio of stocks that you have invested in for the past year. You want to evaluate the performance of this portfolio, so you decide to compare it to the S&P 500 index, which is a common benchmark for large-cap stock investments.
To do this, you gather the following information:
- The total return of your portfolio over the past year
- The total return of the S&P 500 index over the past year
First, you calculate the total return of your portfolio by taking the value of your portfolio at the end of the year and dividing it by the value at the beginning of the year. For example, if your portfolio was worth $50,000 at the beginning of the year and $55,000 at the end of the year, the total return of your portfolio would be 10%.
Next, you look up the total return of the S&P 500 index for the past year. Let’s say the S&P 500 returned 12% over the past year.
Now you can compare the total return of your portfolio to the total return of the S&P 500 index. In this case, you can see that the S&P 500 index outperformed your portfolio, with a return of 12% compared to your portfolio’s return of 10%.
This comparison can help you evaluate the performance of your portfolio and determine whether it is meeting your investment goals. However, it’s important to remember that past performance is not necessarily indicative of future results, and there may be other factors that contribute to the difference in returns between your portfolio and the benchmark.
Final Thoughts
There are many ways to evaluate and calculate investment returns. But ultimately, total return is not a good enough metric on its own. You need something to compare your return to, such as a benchmark or a level of risk. Next, let’s explore 4 different types of risk-adjusted returns.