To evaluate the effectiveness of an investment portfolio, a chosen strategy, or a trading system, an investor needs to be able to quantify the financial investment income. At first glance, the task seems simple, but most beginners cannot solve it. For experts and market participants, one of the defining indicators in this situation is the annual return on investment. What is it and how to calculate it in various cases?
What is the investment income meaning?
The term “investment income meaning” refers to the financial result obtained from investments during the year. This indicator is used universally, for example:
- For asset selection;
- To determine the effectiveness of the investor’s or management company’s money management strategies;
- To compare portfolios;
- For forecasting investment results based on the analysis of historical data and so on.
Annualized return is a relative value. It shows what percentage of investment profits the invested funds have brought. This approach is justified because it allows comparisons to be made at different price levels.
For example, an investor wants to determine which of the stock purchases had more financial investment income, if one paper, bought for $120, brought in $15 of ordinary income from investment for the year, and the other – $1400, but at a purchase price of $11. In this case, it is incorrect to compare the absolute values of the investment profits received, but the calculation of the relative profitability indicator gives an unambiguous answer to this question.
Types of returns
Investment returns can be evaluated from different angles to get a complete picture of investment profits or losses. There are certain formulas for calculating all the indicators, with the help of which an investor will be able to analyze different assets and adjust the strategy.
We tell you about the main types of profitability and how to calculate them:
Nominal yield. This is the actual amount that an investor receives from a certain ordinary asset. For example, a company’s stock was originally worth 10,000$ and after a while, the same stock is worth 11,000$. The nominal return was 1,000$. You can calculate the nominal return as a percentage using a simple formula:
Nominal return = total return / invested funds * 100%.
In this case, 1000$ / 10,000$ * 100% = 10%.
Real Return. This is the rate of return on assets after deducting all expenses – commissions, and taxes, and taking into account current inflation. For example, if the return on assets is 5% and inflation is 7%, the assets have not produced a return, but have reduced capital by 2%.
Real return = nominal return / current inflation
Dividend Yield. This calculation considers the ratio of dividend income from an investment to the average market rates of the stock. It is only calculated if the issuer pays dividends.
Dividend yield = dividend volume / stock value * 100%
For example, from a 10,000$ stock, you received 1,500$ in dividends. In this case, the dividend yield is 15%.
Coupon Yield. This figure and formula are identical to the dividend yield, except instead of stocks, it’s the face value of the bond, and instead of dividends, it’s the coupon payments.
Total return. It takes into account the total return of the asset on the dividend and speculative component at the same time. By calculating the total return, you will find out how much income the investment in this asset has brought you in general. The following formula is used for the calculation:
Total Return = (dividends + stock growth) / asset value * 100%
For example, you bought 10,000$ worth of securities, a year later you received 1,000$ in dividends, and the assets themselves are now worth 11,500$. The total return will be (1000$ + 1500$) / 10,000$ * 100% = 25%.
Final Yield. Relevant when an investor sells an asset, or the issuer closes it. It is the final performance of a particular asset and is calculated using the following formula:
Final yield = ((sale price – purchase price) / number of years of ownership + arithmetic average of dividends per year) * 100%.
Annualized Yield. This is the annualized percentage – how much an asset yields in one year. This indicator takes into account the time of ownership of securities. It allows you to calculate how much financial investment income an investor would have earned if they had kept the asset in their portfolio for a year. It is calculated using the XIRR method, which we will describe in detail in the next section.
The analysis of all return indicators will help the investor to evaluate the efficiency of investments, compare assets, and choose the most optimal ones to achieve the goal as soon as possible following the chosen investment strategy.
XIRR method. Also, this method is called – money-weighted return.
The method also takes into account all additions and withdrawals from the portfolio, which were made during the investment period. The calculation formula is extremely complicated, but it is enough to use Excel. How to calculate?
- The first thing we do is to write out the dates of replenishments. We take the same values for clarity. Let’s say we opened an account on 01.01.2024 and deposited 2500$ for 4 months. If you suddenly withdraw money, we record it with a minus sign;
- Further, we designate the final date of the investment period as 31.12.2024, and the final amount of the portfolio – as 30000$, but with a minus sign (it is important);
- Now we enter into Excel the function XIRR: =XIRR (amounts; dates) – ready, we get the annual yield.
The meaning of this function is as follows:
Incoming flows (initial amount + deposits) are equated to outgoing flows (final amount + withdrawals). Ideally, the two sides of the equation will not be equal, because they differ just by the amount of yield we are trying to find. The function calculates this yield taking into account the different deposit times. It selects the rate at which the difference between incoming and outgoing flows will be equal to 0.
That is, if the obtained rate is multiplied by each cash flow amount and the values are added up, we will get a sum equal to zero. Because of this error, the calculation automatically selects the value closest to fulfill the condition. This formula was originally designed and used to evaluate investment projects, and their profitability and for risk assessment.
Conclusion
When you see another investor writing about his financial investment income, make sure to ask what method of calculation he uses, as all methods show different figures.
