Many are quite familiar with ROI = Return on Investment.
It is one of the basic calculation investment.
Besides ROI, there are other methods that we can use to measure investment return.
Today we are going to look into 4 ways how investment return can be calculated
a) Total Return
b) Historical Return
c) Expected Return
d) Real Rate of Return
Sometimes it is confusing when there are so many types of return calculation.
Which one should we use?
Let's look at each one of them now.
a) Total Return
The total return from investment can be derived from two components:
i) Income
This income can be from
- interest paid on bonds
- dividend paid on shares
- distribution on unit trusts
- Real Estate Investment Trusts
- rental income from properties
ii) Capital Gain / Appreciation
This is mainly profit made from the price increase.
So
Total Return = Income + Captal Gain
This combination is also called Total Dollar Return (TDR).
Total Dollar Return = Income Return + Capital Gain Return
The total return of investment involves a certain holding period on that particular investment.
By bringing in a time factor, the TDR over a certain period of time is known as Holding Period Return (HPR).
TDR = in abosulte term (RM)
HPR = in relative (%) term
Annualised Holding Period Return
n = number of years
Example:
Ali bought 50,000 shares of Tenaga National Shares for RM10 per share last year.
A year later, Ali received a dividend of RM1.00 per share.
The current market price of the share is RM15 per share.
i) Total return = Income + Capital Gain
= RM1 + RM 3 = RM4 per share
For 50,000 shares = RM5 x 50,000 = RM200,000
ii) HPR = TDR / Total Investment
200,000 / 500,000 = 20%
Suppose Ali hold it for 6 months only, therefore
Annualised HPR for 6 months
= [ 1 + 0.2 ] ^ 1/ (6/12) - 1
= 1.2 ^ 2 - 1
= 0.44
= 44%
By using Annuliased HPR, we can now compare different investments for the different holding period, and then conclude the performance.
Example:
So share A is better than Real Estate B.
b) Historical Rate of Return
The historical rate of return refers to the rate of return on investment based on the historical (past) data of that investment.
There are 2 methods to calculate
i) Average Return (Arithmetic mean return)
ii) Geometric mean return
return relative = 1 + HPR
In certain situations, the geometric mean return (or the compounded rate of return) is more accurate than the average return.
So be careful how the number is published.
Example:
i) Arithmetic Mean Return
= [ 100% + (-50%) ] / 2
= 25%
ii) Geometric Mean Return
= [ (2.00) (0.50) ] ^ 1/2 - 1
= 0%
So you can see, if use average mean return, the number is bigger.
But in actual fact, 0% is more accurate, because, after 2 years, the investment value is back to RM10, which means there is no growth.
We will continue the other 2 ways of calculation in future articles.
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