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Understanding Investment Returns

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by: No more debt !
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Word Count: 383
Date: Mon, 29 Mar 2010 Time: 11:48 PM

There is often a lot of misguided talk, sometimes boasting, about the level of returns people get on their investments. This can leave some feeling as though theyve missed out.

Before you get too caught up in what others are (apparently) achieving you need a good understanding of some important investment return concepts. You need to make sure you are comparing apples with apples and this is often very difficult to do.

We look at three fundamental issues that need to be considered when reviewing investment returns.

First, investment returns need to be calculated correctly

Some returns are quoted for an entire time period, while others are are quoted on a per period basis.

Joe says he has achieved a 36% return on his investment. Sounds impressive, yet not so impressive when you find out that he invested $10,000 a month ago and its now grown by 3% to $10,300.

Returns are mostly quoted on an annualised basis for periods of a year or greater. However, for periods of less than a year returns are quoted on an absolute basis with reference to the period (e.g. 3% for one month). Joe has taken his one month return and multiplied it by 12 to give himself a notional annual return of 36% .

Mary says her investments doubled over the past 5 years. By her reckoning, she got a return of 20% p.a. which she claims is much better than the markets return of 17% p.a. However, she has calculated her return using a simple (or arithmetic) return calculation (i.e. 100% ÷ 5).

The market rate of return (along with the majority of investment returns) is calculated using a compound (or geometric) return. In Marys case, the compound return of her investment is (1 + 100%)n 1, where n = 1 divided by the number of periods (=5). Marys compound return was only 14.9% p.a. well below the markets return of 17% p.a.

Dominic has had a volatile ride with his investment. Since initially investing his $10,000 , he has kept track of his annual returns. The investment jumped by 50% in the first year, then fell by 40% the next year and then rose by 8% in the third year. He believes his return is 6% p.a. (i.e. +50% 40% + 8% = 18% ÷ 3 years = 6% p.a.)

About the Author

Wealth Foundations is an independently owned personal financial advisory firm that offers wealth management and strategic financial planning services.  For more information, visit Wealth Advisers.

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