Return of an investment
The return of a financial investment is the measure of the income generated by that investment. It can be expressed in absolute value (indicated in the currency of the investment, for example in euros) or in proportion to the invested capital and the duration of the transaction (so indicated as a percentage on an annual basis).
This is an element to be taken into due consideration as part of your money management strategy, along with financial risk. Being able to calculate the “expected” return of an investment is highly important for careful and focused asset management.
The financial return can be calculated mathematically and is broken down based on the specific financial instrument being acquired.
As highlighted, careful investment management must include the expected return within the strategy. Indeed, investing with no profit goal means not being able to determine whether the transaction was successful: it is not possible to make comparisons and analyses or draw conclusions without a benchmark to be used as a basis.
But being able to understand what the return that you can expect from an investment will be is rather complex. First of all, the return of an investment is necessarily proportionate to risk. This means that the riskier an investment is, the higher the return you can expect from it and, vice versa, the lower the risks, the lower the profit.
But how can you calculate the return of an investment? It is important to note that the return of a financial instrument may be:
- simple, when it is calculated as the change in the value of an asset, compared to the value that it had at the start of the observation period. If for example the asset initially was worth 100 and after one year it was worth 110, the return will be 10%.
- an average, when it is calculated as the weighted average of the average returns it is possible to obtain from the various assets present, where the weights will be the percentage of the total equivalent value invested in each security.
An additional return indicator worth mentioning is the money weighted rate of return, which measures the overall return of a portfolio, taking into consideration the investor’s contribution and redemption decisions.
To calculate the return of a financial asset, different formulas are used depending on the information you want to obtain.
Calculating the Total Return of a financial instrument for a given period is immediate, and the following formula is used:
where M (principal and interest) is the value of the portfolio at maturity, and I (Investment) is the value of the portfolio at the start of the period. Here the change in the value of a portfolio is represented, including capital gains and capital income, in proportion with the value of the investment. Possible liquidity flows, withholding taxes and investment duration are not taken into account.
To be clear, in financial mathematics the principal and interest is the monetary value referring to the end of a time period inclusive of the initial principal and the interest accrued in the reference time period.
It is worth underscoring that the total return of the investment should be calculated with respect to the most recent capitalization of a financial instrument and not as the sum of the individual returns.
For example, if €10,000 is invested and in the first year a return of -50% is recorded to then, in the subsequent period, have a return of +70%, it is wrong to think that a total return of +20% has been obtained, and therefore, in absolute terms, €12,000. Indeed, losing 50% in the first period, we will have €5,000. At the end of the second period, the return of 70% should be calculated on the basis of the €5,000, obtaining a total of €8,500 (lower than the initial capital).
Editor’s note: This article describes the return on investment as a general concept. Besides articles are written with with particular focus on the Italian regulation. Although there are common EU laws, regulation may vary from country to country. For further information visit your Country’s Central Bank and Conduct Authority websites, or contact your bank or investment banker.