The return on investment is a general term that refers to how well an investment is performing over time. There are many different ways of looking at return on investment, however, which can be confusing if you're trying to decide which investment is really doing the best. Before you're awed by a specific return figure, make sure you know what it means so you can make an apples-to-apples comparison with your other investment options.
When you look in the newspaper, you only see whether the stock price has gone up or down. As a result, many people overlook the power of dividends in figuring the return on investment. See, when a company pays out a dividend, it's transferring a portion of its value to the shareholders, so the stock price is less than it would otherwise be, if all the value remained with the company. So, when you're figuring the total return, you include any dividends received as well as the increase in the price of the stock.
The total return on investment measures how well the investment has done over any specified period of time in raw dollar figures. For example, you could calculate the total return on a stock over one month or over 10 years. Suppose you invested $5,000 in a stock, you received $200 in dividends while you owned it, and it's now grown to $5,500. Your total return is $700 -- $200 in dividends and $500 in stock appreciation.
The downside to hearing a total return figure, whether it's $700 or $7,000, is that you don't know how much money someone had to invest to generate the return. For example, while $7,000 sounds much more impressive than $700, the investment loses its luster if you learn the $7,000 return was generated by a $500,000 investment when the $700 return was generated with only a $5,000 investment. So, to account for investment size, you can use the percentage return instead. The percentage return equals the total return divided by the investment amount, multiplied by 100. For example, a $700 return on $5,000 means a 14 percent return.
Average Annual Return
The average annual return takes the percentage return one step farther to take into account how long you held the investment, but the math gets more complicated, too. Even a 14 percent return isn't so snazzy if it takes eight years to earn it. To figure the average annual return, add 1 to the percentage return as a decimal. Then, raise that number to the power of 1 divided by the number of years it took to accumulate. Finally, subtract 1 from the result and multiply by 100. For example, if your 14 percent return took five years, add 1 to 0.14 to get 1.14. Then raise 1.14 to the 1/5th power to get 1.0266. Then, subtract 1 and multiply by 100 to find the investment averaged an annual return of 2.6 percent.
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