I Don’t Care About Your Investment Returns

Alright alright alright, who wants to talk investment returns?

Think you know what I mean when I ask that question? Well, let’s find out. Then we’ll get into why I don’t care how high or low your return was last year, and why you shouldn’t care about mine.

First things first: a return is a profit on investment.

It’s the amount the value of your investment has changed (capital gains or losses), plus the amount you’ve earned from interest or dividends (if applicable). It can be positive or negative, and can be described either in dollar amounts or percentages. That’s the very simple answer.

But like many things, there is a more complicated answer too. Let’s look really quickly at those different elements of a return.

Change in value: this one is easy. If you buy a stock for $100/share and it goes up to $102/share, the change in value is $2. If it goes down to $98, it’s -$2. Remember that capital gains and losses aren’t realized (made into fact) until you sell your investment.

Dividends: I’ve covered this before, but the basics on dividends is that you receive them when a company decides to share some of the company’s earnings with shareholders.

Interest: this is the charge for borrowing money. When you earn interest on, say, a savings account, it’s because you have loaned money to the bank. Hint: your stock investments get earnings, not interest…no matter how many times people talk about “compound interest growth of stocks.”

(one of my pet peeves is people talking about “interest” on stock investments)

The More Advanced Stuff

All of that above is a very easy way of describing a nominal return. But there are other ways to describe returns. They are all similar, but there are slight differences. Let’s look at some of them.

Return on Investment (ROI)

This is when you measure the amount of the return relative to the cost. For instance, if you buy an investment at $100 and sell when it hits $102 (no dividends or anything), you have a ROI of 2%. You can find that dividing the difference of the sale amount and purchase amount ($2) divided by the purchase amount. That is: ($102 – $100) / $100 = 0.02 or 2%.

ROI is a good measurement when you aren’t necessarily paying the full price for something upfront. For instance, it’s often used when talking about rental properties. If you buy a rental but use a mortgage, your cost is not the price of the property. Your cost is however much you put down, plus whatever you’ve put into the property (such as repairs and upgrades).

ROI is nice because it’s easy to understand and calculate. However, it’s not perfect. It isn’t time based, so it’s not good for determining return over a set period of time. That makes it difficult to compare to other investments. In that case, you might want to use a different method.

Rate of Return

This is the amount of gain or loss of the investment over a specified time. The annual rate of return is the amount over one year. This is usually what people are referring to when they say “my return was…” but unless you ask, you don’t know that.

Compound Return

This is the rate of return that represents the cumulative effect of growth/loss over time. For instance, if $100 is invested for 5 years at variable rates of return it might look like this:

$100 * 1.07 (that’s a 7% ROR) = $107

$107 * 1.15 (15% ROR) = $123.05

$123.05 * 1.03 (3% ROR) = $126.74

$126.74 * 1.13 (13% ROR) = $143.22

$143.22 * 1.12 (12% ROR) = $160.40

You can see that the overall compound return is 60.4%, based on a profit of $60.40 over the $100 initial investment.

It can also be expressed in annual terms. When expressed in annual terms, a compound return might be referred to as Compound Annual Growth Rate (CAGR). In this case, the CAGR for the 5-year period would be about 10%:

$100 * 1.10 = $110

$110 * 1.10 = $121

$121 * 1.10 = $133.10

$133.10 * 1.10 = $146.41

$146.41 * 1.10 = $161.05

Yeah it’s off by a few pennies, but you see the point. If you want to get really specific, the actual CAGR for a $60.40 compound return over 5 years on a $100 initial investment is 9.91%.

$100 * 1.0991 = $109.91

$110 * 1.0991 = $120.80

$121 * 1.0991 = $132.77

$133.10 * 1.0991 = $145.93

$146.41 * 1.0991 = $160.39

Annualized Returns

Another way to say CAGR is annualized return. This can be calculated with this equation:

Holding Period Return (HPR)

Also known as yield, this is the total return over a period of time. It can either be expressed annually or not, and is good for comparing the returns for investments held for different periods of time. The formula is similar to annualized return:

Income + (End of Period Value – Initial Value) / Initial Value

So for our $100 investment example, we can see that the 5-year holding period return is 60.4% if there was no income (such as dividends).

HPR = $0 + ($160.40 – $100) / $100

HPR = $0 + $60.40 / $100

HPR = 60.4%

The annualized HPR formula is a bit more tricky than using CAGR, but handy if you need to add in income received during the holding period.

Annualized HPR = {[Income + (End of Period Value – Initial Value)] / Initial Value + 1} ^ 1/t – 1, where t is the number of years in the holding period.

For our example, that’s:

Annualized HPR = {[($0 + ($160.40 – $100)) / $100] + 1} ^ 1/5 – 1

Annualized HPR = {[(0 + 60.40) / 100] + 1} ^ 0.2 – 1

Annualized HPR = (0.604 + 1) ^ 0.2 – 1

Annualized HPR = 1.0991 – 1

Annualized HPR = 0.0991

Annualized HPR = 9.91%

So at first glance, it seems like there is no benefit to using annualized HPR instead of CAGR, but remember that CAGR doesn’t specifically remind you to include income throughout the holding period – HPR does.

Real Rate of Return

Now we get into the real nitpicky stuff. Real rate of return looks at your annual rate of return and adjusts for things like inflation and other effects. This allows you to make comparisons based on purchasing power, not just dollar amounts. This is a great way of seeing actual growth in your investments.

In really simple terms, it looks like this. If you have a savings account with 1% interest and inflation rises by 1%, then your real rate of return is 0%. If you have an index fund with a 7% annual return and 3% inflation, you have a 4% real rate of return.

In reality it’s a bit more complicated because nobody buys everything on exactly January 1st and keeps it the full year. And nobody matches the inflation trackers’ purchases exactly for their real lives. But it’s a fair assessment for measuring purchasing power.

And just to make this even more complicated, I haven’t even covered all of the ways of measuring returns yet! There are more! But enough of the boring stuff.

Why I’m telling you this

First off, I hope this makes it clear that when somebody is telling you their return, you don’t necessarily know which kind of return they are talking about. Last year’s rate of return? CAGR? Real rate of return?

Second, because you need to know which kind of return you are actually aiming for. A dividend-producing stock that gives you 4% in dividends and an annual rate of return of 4% is not the same thing as a non-dividend stock with a 4% CAGR! And it’s not inferior to a growth stock with a 7% rate of return, but it might be inferior to a stock with a 7% real rate of return.

When you invest in something, your investment choices should be based on achieving your goals, not on beating some arbitrary metric like “the market’s return” or your brother’s returns.

It’s really important that you care about your returns

There’s a popular saying in the Air Force – nobody cares as much about your career as you. The same goes for your investments. You need to be paying attention to your returns…nobody else does.

If your goal is to double your money in 10 years, then you can use the Rule of 72 to determine that you want a CAGR of 7.2%. If you want your purchasing power to double in that time, and inflation is predicted at 3% average annually, then you need a CAGR of 10.2%.

You can then choose investments that are likely to get you to your goal.

Now, somebody is thinking in their head “past performance is no indication of future results!” And that’s 100% true. You shouldn’t choose a specific stock or fund or even a house based on past performance. But you can pick an asset class with that in mind.

If you want an average 8% return for the next 20 years, savings accounts aren’t going to do it for you. Bonds almost certainly aren’t. TIPS? Nope. You need to be looking at stocks or maybe some real estate or other, higher potential return (but higher risk) assets.

And if you already have enough money for your goal (say, an emergency fund) you don’t need high levels of risk to keep your purchasing power level. You can use a much safer asset, such as certificates of deposit, maybe some government bonds, something like that.

So hopefully, all of that will help you better speak the language of investment returns. Now let’s talk about why I don’t want to hear about it.

Why I don’t care about your investment returns

Your goals are not my goals.

All I care about when it comes to your returns is “Are they sufficient to meet your goals? Is the risk/reward ratio appropriate given those goals?”

If they are, then good job. If they aren’t, let’s talk about what you should be looking to adjust.

Why you shouldn’t care about my investment returns

First of all, you shouldn’t care about my investment returns because I’m not going to tell you anyway. Not my current ones, not now; I’ve already shared my 2007-2013 returns and that’s plenty. So don’t spend time worrying about something you have no control over.

But also, the only person whose investment returns you should care about (beyond your immediate family) is a financial advisor, if you have one.

And I’m not your financial advisor.

I don’t recommend investments. I don’t share with you what I’m invested in. Ergo, there is no reason to know how I’m doing, because I won’t be recommending those things to you. I’m here to teach you how to think about money, not create a financial plan for you.

Now your financial advisor? Yeah, sure, ask them. It shouldn’t be the only criteria you use to discover if they are a good advisor (remember their goals are not yours!) but you can ask. Make sure their philosophy on investing to meet goals aligns with yours.

Now I get it, some people think that knowing my returns will give them an indication of whether they should trust what I say. I’ll I can say to that is ¯\_(ツ)_/¯

I’m fairly upfront, if not completely transparent. I invest in a buy-and-hold style, I’m happy to match the market (as seen in that 2007-2013 review), and I’m not here to tell you about my money…I’m here to teach you how money works. So my returns aren’t important. You learning how to maximize your returns while balancing risk is important.

So stop paying attention to everybody else’s returns and start figuring out whether yours are what you need 😉

Pop Quiz: have you done the math on what CAGR and average real rate of return you need to earn to reach your retirement goals? If not, there’s your homework assignment for the weekend.