Return is income received by an investor on an investment.
The rate of Return is expressed as a percentage of the principal amount invested. The amount of Return on an investment is a function of three things:
- The amount invested,
- The length of time that amount is invested, and
- The rate of Return on the investment.
Depending on the type of investment, all of those things can vary.
Rates of Return are always quoted as annual rates. In other words, what percentage of the amount invested would be earned if the investment were held for one full year?
Annual Rate of Return = Return Received for One Year’s Investment/ Average Balance of Amount Invested
Return on Investment (ROI) is the value created from an investment of time or resources.
Return on investment can help you make decisions between competing alternatives. For example, if you deposit money in a savings account, the investment return will equal the interest rate the bank gives you to hold your money.
Investments are made to earn returns. The return expectation could be an amount received as interest, stock dividend, capital appreciation, etc. Different assets have different types of returns.
Some Factors Affecting Investment Returns
- Rating of an investment.
- Liquidity of an investment.
- A time horizon of investment
Return on Investment Calculation
Return on Investment (ROI) is the ratio of a profit or loss made in a given period expressed in terms of an investment. It is defined as a percentage of increase or decrease in the investment value during the year in question. For example, if you invested Rs 1 lakh in a share and its value rises to Rs 1.10 lakhs by the end of one year, the Return on the investment is 10%, assuming no dividends were paid.
Basic ROI Formula
The basic ROI formula is: (Net Profit / Total Investment) * 100 = ROI.
Holding Period Return (HPR)
HPR = [Annual Income + (Price at the end – Price at the beginning) ] / Price at the beginning.
Use of the ROI Formula Calculation
ROI calculations are simple and help investors decide whether to take or skip an investment opportunity. The calculation can also indicate how an investment has performed to date. Therefore, when an investment shows a positive or negative ROI, it can indicate its value to the investor.
Using an ROI formula, an investor can separate low-performing and high-performing investments. With this approach, investors and portfolio managers can attempt to optimize their investments.
Types of Returns on Stocks
There are two ways that you can receive a return on stocks.
- Capital Gains
One is the dividend payment, a share of profits given to stockholders. If a company makes money over a certain period, it can decide to distribute at least some of the gains in the form of dividends. Dividends are usually paid quarterly or yearly in cash or more shares of stock, i.e., stock dividend.
Many stockholders receive a return on stock when they sell it. Selling stock for more than you paid for it results in a capital gain. A capital gain is a profit from selling a financial asset such as a stock or a bond. A capital loss is an amount lost when a purchase is sold for less than its cost. As with other forms of income, the government taxes the amount received in dividends or capital gains.
Rate of Return
The rate of Return on stocks is always expressed as a percentage of the original investment and figured annually. For example, suppose INR 100,000 earns INR 5,000 interest in savings accounts for one year. The rate of Return on the investment is 5 percent (INR 5,000/ 100,000). A single share of stock whose value increases from INR 500 to INR 550 in a year and pays an INR 50 dividend during the year has a 20 percent rate of Return (INR 100 return/ INR 500 original investment = 20%).
Conclusion: Investors assume Risks to get Returns
Most investors are assumed to be risk averse. This means that people are willing to accept a lower return in exchange for reducing risk in an investment. Because of this risk-aversion of investors, in most cases, risky investments must offer higher expected returns than less risky investments to get investors to purchase them and hold them. Similarly, an investor must be willing to accept a lower return to have a lower risk.