As an investor, you need to be able to tell how profitable your portfolio is in order to make the next decision about buying, holding or selling. Do not worry, there is no need to be a math genius to do things right.
Although some formulas are more complicated than others, they are all perfectly in reach for the average investor who is armed with a calculator. This article aims to provide you with the tools you need in order to keep your investments in check and make sure you’re making money, and not the other way around.
Total return
This is perhaps the most important formula, but it has the merit to include dividends, which people sometimes tend to forget when calculating the return of a stock.
Formula:
Total return = ((Value of investment at the end of the year – value of investment at the beginning of the year) + Dividends) / Value of investment at the beginning of the year
Let’s take an example. Let us pretend you bought Amazon stock on the 30th of April at $2’474 and that it is now worth $3’531. Apple was quite generous and distributed $420 in dividends during this time. The total return is thus the following:
- Total return = (($3’531 – $2’474) + $420)/$2’474
- Total return = ($1’057 + $420)/$2’474
- Total return = $1’477/$2’474
In this specific case, the total return is 0.5970 or 59.70%. The only weakness of this formula is that it does not take account of the fluctuation in money value over time.
Simple return
The simple return is very similar to total return, with the difference that this is a calculation that takes place after you have sold the investment.
Formula:
Simple return = (Net Proceeds + Dividends)/ cost basis – 1
Let us say you bought a stock for $4’200 and that you paid a $20 commission. Your cost basis would be $4’200 + $20 = $4’220. If you sell the stock for $5’300 with another commission of $20, your net proceeds would be $5’280. Assuming your dividends amounted to $200, your simple return would be the following:
- Simple return = ($5’280 + $200) / $4’220 – 1
- Simple return = $5’480 / $4’220 – 1
- Simple return = 2986 – 1
In this case, the simple return would be 0.2986 or 29.86%. This method shares the same flaw as the total return in the sense that it does not tell you anything about the timeframe of the investment e.g. 30% in a year is great, 30% over the course of 10 years, not so much.
Compound annual growth rate
In order to take the value of money in your investment into account, you need to add some tools to your toolkit. But do not worry, things do not get much more complicated. As mentioned before, a 30% profit might be great over a short period but is much less impressive over a lifetime. Therefore, we need a way to take the timeframe into account.
Formula:
CAGR = (Ending value/Beginning Value)^(1/n) – 1
Alright. This might look fancy for some, but it is simpler than it looks. Let us illustrate it with an example. You invested $20’000 in a portfolio that had the following returns:
- From Jan 2012 to Jan 2013, your portfolio grew to 28’000 (40% in year 1)
- On Jan 2014, the portfolio was worth $30’000 (or 7.14% in year 2)
- On Jan 2015, the portfolio ended at $40’000 (33.33% in year 3)
Note that return on investment are very different in the different years. The compound annual growth rate will smooth out the investment’s performance. We calculate it as follows:
- CAGR = ($40’000/$20’000) ^ (1/3) – 1
- CAGR = 2 ^ (1/3) – 1
- CAGR = 1.2599 – 1
In this case, the compound annual growth rate is 0.2599 or 25.99%. The number tells you the growth your initial investment should have each year in order to fall exactly on the end value. This can be a very good value to have in order to compare your investment with different alternatives and to have a better sight of how much you really make per year on a given instrument.
And there you have it! Now you are familiar with the three main tools used to calculate a return on investment. I strongly encourage you to use these formulas and get familiar with them in order to better understand your investment. And if you are already familiar with them, a little reminder never hurt anyone.
Source:
https://www.thebalance.com/determine-return-on-investment-3140687
