|'Return' is the fundamental measure
of investment performance
Are you sure you understand 'interest'?
If you deposit £100 for a year at 6% interest you will get
£106 back. This is your £100 deposit (' principal') and £6
of interest ('income').
You might look on the £100 as an investment
- putting money away to get more back in the future. The £6 could
then be called the 'return on the investment', or, in short, a '6%
return'. It is also a 6% income return.
If you buy a gold coin for £100 and sell it a year later for £106
you have again made a 6% return. This time you have made this money
through capital appreciation. So it is called a 'capital return'.
But it's £6 just the same.
If you invest £100 in a share and it pays a dividend of £3 and also
goes up in value to £105 you have made a total of £8. Cleverly,
this is called the 'total return', or just 'return'. As an investor,
you do not care about the separate capital and income returns (except
for tax reasons). You just care about your total return.
Get used to adding your income return (or 'interest'
or 'yield' or 'dividend') to your capital return (or 'capital gain')
to get your total return. In the example, 3% + 5% = 8% total return.
If your £100 goes to £108 in year 1 and to £118.80 in year 2, a
bit of maths tells you that you made 8% in year 1 and 10% in year
2. (10% of £108 is £10.80).
There's a way of reducing this information
to a single 'annualised return' or 'annual return'. In this example
you have made a return of 18.8% over 2 years. This is equivalent
to 9.0% per annum compounded (not 9.4%, which would be simple interest).
If you want to understand the maths (which is not necessary). You
would refer to your investment as making an 'annual return of 9%'.
As you may guess, it is possible to calculate
an annual return from any old mish-mash of cash flows over any period.
Look in any investment textbook for 'Internal Rate of Return (IRR)'.
All other things being equal, you want the highest
possible returns from your investments.