What is … Total Return?
Total return is a key concept in investing that provides a complete picture of an investment’s performance. Unlike basic measures such as price appreciation or dividend yield, total return considers all forms of income and capital gains, making it a more accurate metric for evaluating an asset’s true profitability. In this article, NMTBP breaks down what total return is, how it’s calculated, and why it’s crucial for investors. It refers to an investment’s overall profit or loss over a specific period and includes two primary components:
Capital gains (or losses): The increase (or decrease) in the value of the investment. This reflects the price appreciation or depreciation of the asset over time
Income: The income generated from the investment, such as stock dividends, interest payments from bonds, or rental income from real estate. In some cases, it also includes distributions from mutual funds
Total return combines both components to provide a holistic view of an investment’s performance, encompassing all aspects of returns, not just price changes
How to calculate Total Return
To calculate the total return, you need to consider both price changes and any income the investment generates
Let’s say you buy a stock for £100, it appreciates to £120, and during the holding period, you receive £5 in dividends. The total return would be:
(120−100+5)×100 =25%
100
This total return reflects both the price appreciation (£20) and the dividend income (£5), providing a more comprehensive view of your investment’s profitability than just looking at price growth alone
Total Return vs. Price Return
It’s essential to distinguish between total return and price return.
Price Return: Only accounts for the change in the investment’s price over time and does not include any income. For instance, if a stock’s price goes from £50 to £55, the price return would be 10%
Total Return: Includes both the price change and income. If the same stock paid £2 in dividends, the total return would be higher than the price return because it adds income to overall performance
The Importance of Total Return
Comprehensive performance measure: Total return gives investors a complete view of an investment’s performance, factoring in all aspects of profit (or loss). This is especially important when comparing different types of assets, such as high-dividend stocks vs. growth stocks
Income consideration: Some investments, particularly bonds or dividend-paying stocks, provide substantial returns in the form of income. Ignoring these income components could lead to underestimating the performance of income-generating assets
Compounding effect: Reinvesting dividends or interest payments can lead to compound growth, further enhancing the total return over time. A stock that appreciates in value and provides regular dividend income that gets reinvested will grow faster than one where the income is ignored
Better comparison across asset classes: Different asset classes, such as stocks, bonds, and real estate, generate returns differently. For example, stocks may offer price appreciation, while bonds might offer more stable income. Total return helps investors make better comparisons by standardising the performance measures across different types of assets
Total return for different investment types
Stocks: Total return includes price appreciation and dividends. Growth stocks might have a higher capital gain but lower dividends while dividend-paying stocks provide income alongside price gains
Bonds: Total return for bonds includes interest income (coupon payments) and any capital gains or losses based on price changes, which may occur if you sell the bond before maturity or interest rates fluctuate
Mutual funds and ETFs: Total return in mutual funds or ETFs accounts for price changes in the fund’s share price and any dividends or interest payments, which are often reinvested automatically
Property: The total return for real estate investments includes rental income and the appreciation in the property’s value. This is why total return is vital for real estate investors, who benefit from both ongoing cash flow and asset appreciation
Total Return and taxes
One factor that can affect total return is taxes. Depending on the country and the type of investment, dividends, interest, and capital gains may be taxed at different rates. Investors must consider the after-tax total return to get a clearer picture of their earnings, especially in tax-sensitive portfolios
For example, dividends may be taxed differently than capital gains, and bond interest could be taxed as regular income. Proper tax planning can help maximise the total return by minimising the tax impact
Total return is one of the most important metrics for evaluating an investment’s performance. Factoring in both capital gains and income provides a complete picture of how an investment grows over time. Whether you’re comparing stocks, bonds, or other assets, using total return as a benchmark ensures you’re not overlooking any part of the profitability equation
Investors who focus solely on price changes or ignore the role of dividends and income may miss out on valuable insights. Understanding and calculating total return will help you make better, more informed investment decisions that take into account all sources of wealth creation
Leave a reply
You must be logged in to post a comment.