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What Is Total Return?
Total Return is the complete measure of an investment's performance that combines both capital appreciation (or depreciation) and income received. Unlike looking at price movements alone, Total Return provides investors with the full picture of how their investment has performed by including all sources of return - both the changes in the asset's price and any distributions such as dividends or interest payments.
Understanding Total Return is crucial because focusing solely on price movements can lead to misguided investment decisions, potentially causing investors to sell profitable positions based on incomplete information.
Why Focus on Total Return?
Total Return is essential for making informed investment decisions for several reasons:
- More Accurate Performance Measure: While share price movements are easily visible, they tell only half the story. Total Return captures both price changes and income payments, providing a complete view of investment performance.
- Prevents Emotional Decision-Making: Investors who understand Total Return are less likely to make emotional decisions based solely on price movements shown on trading screens.
- Better Comparison Tool: When comparing different investments, Total Return allows for a fair assessment of their relative performance, especially when comparing income-focused versus growth-focused investments.
- Long-term Perspective: Total Return encourages investors to think longer-term and appreciate the power of reinvested dividends and compound returns.
How to Calculate Total Return
The basic formula for Total Return is:
Total Return = (End Price - Start Price + Income Received) ÷ Start Price × 100%
Let's look at two real-world examples:
Example 1: The 5% Gain That Looks Like a Loss
- Purchase price: $1.00
- Current price: $0.95 (down 5%)
- Dividend received: $0.10
- Total Return calculation: ($0.95 - $1.00 + $0.10) ÷ $1.00 × 100% = +5%
While the share price shows a 5% loss, the Total Return is actually a 5% gain when including the dividend payment.
Common Misconceptions About Returns
Many investors fall into these common traps when evaluating their investments:
- Chart Tunnel Vision: Focusing exclusively on price charts, which don't show dividend payments
- Trading Screen Bias: Making decisions based on the red or green colours showing price movements alone
- Ignoring Income: Overlooking the significant contribution of dividends to total investment returns
- Short-term Thinking: Focusing on short-term price movements rather than long-term total returns
Why Total Return Matters for Different Investors
Understanding Total Return is crucial for various types of investors:
- Income Investors: Particularly important for retirees and income-focused investors who rely on regular distributions
- Growth Investors: Helps in comparing growth stocks against dividend-paying stocks on a fair basis
- Long-term Investors: Essential for understanding the true power of compound returns over time
- Financial Advisers: Critical for properly evaluating and comparing investment options for clients
Best Practices for Evaluating Total Return
When assessing investment performance, consider these key points:
- Look Beyond the Chart: Always consider both price movements and income payments
- Track All Distributions: Keep records of all dividends and distributions received
- Consider Time Periods: Evaluate Total Return over various time periods to get a complete picture
- Compare Appropriately: When comparing investments, use Total Return rather than price movement alone
Making Better Investment Decisions
Understanding Total Return may lead to better investment decisions by:
- Avoiding Premature Sales: Preventing the sale of profitable positions that appear to be losing money
- Appreciating Income: Recognizing the value of income-producing investments
- Supporting Long-term Holding: Encouraging longer holding periods by showing the full benefit of income payments
- Improving Portfolio Assessment: Enabling better evaluation of overall portfolio performance
Put simply, Total Return is a true measure of investment performance. While share prices may fluctuate and charts may show declines, understanding Total Return helps investors make better-informed decisions and avoid selling profitable positions based on incomplete information.
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