Maddy: “What is return on investment?”
Returns on investments are the annual growth percentage. So an investment that started the year with $10,000 and ended the year with $11,000 grew $1,000. $1,000 divided by the initial $10,000 is 0.10 or 10%. Of course, if part of the reason it grew to $11,000 was because you added money, the return would have been smaller. If you had withdrawn some money and still ended up with $11,000, the return would actually have been bigger than 10%.
A good approximation for return on investment is:
[Ending balance – Beginning balance –Deposits + Draws]
[Beginning balance + 0.5 Deposits – 0.5 Draws]
This is a before-tax return. Some news journalists have used a similar formula and said that if your draws were to pay the taxes you would get an after-tax return. Not so! The equation doesn’t care about the reason you withdrew your money.
The search for larger returns on investment is important for both working people and retirees. Working people benefit from greater investment growth and retirees benefit from larger current income, often in the form of interest and dividends. The return on a stock is the sum of the increase in price of the stock plus the dividend percentage. For that reason, the growth of a stock market index understates the total return because it ignores the stock dividends unless specifically called total return.
Few people recognize the volatility of stocks. Figure 1 below represents the year to year variation in total returns for large company stocks. The illustration is for the Standard & Poors 500 index which essentially represents the largest five-hundred capitalization stocks on the market. Smaller stocks are even more volatile.
Some people think that bonds remain at constant values. They don’t. See Figure 2. That’s because interest rates change all of the time. When interest rates go up, the value of a bond goes down. This hits bond mutual funds very hard. The way to avoid this is to buy bonds yourself from a broker or the government—and then hold them to maturity when you’ll get your full principal back.
High returns almost always equate to high risk, and low returns should equate to low risk but don’t always. That’s because fees and costs can produce low returns even though the underlying securities have high risk. It’s hard to overstate the penalties of high fees and costs. Some people think that a fee or cost of 1% or even 2% is a small number. However, this small number is a large percentage of the underlying security return, so if a mutual fund charges you 2% a year on an investment that returns 7%, you get only 5%. If inflation was 3%, your real gain was only 2%, the same amount as your mutual fund took from you for fees.
When looking at returns over a long period of time, those who make regular deposits generally gain about 1% from dollar-cost-averaging while retirees who make regular withdrawals generally lose about 1% from reverse-dollar-cost-averaging. Few planners account for this reduction.
Figure 1. Stock values fluctuate—sometimes wildly even though they may represent large stable companies as for these S&P 500 stocks. Source: Global Financial Data.
Figure .2. Bond interest rates change all of the time, but much more slowly than stocks. Source: Global Financial Data