How to calculate return on your investment
After reading this guide you will be able to calculate your investment returns and easily assess the performance of any portfolio.
What is the return on investment?
The possibility of earning a return is what mainly attracts people to invest in certain assets. When investors measure the return they usually look at profit made in relation to the initial investment or initial cost.
If you learn to calculate the return on your investment and on your portfolio, it will help make the comparison between different assets allowing you to make better investment decisions.
Let's say that portfolio A and portfolio B have both generated €16,000 in profits. At first glance, it seems that both have the same performance because they have an equal amount of profit. But in the investing world, this comparison may be incorrect. We can't compare the performance of different assets or portfolios, relying solely on the monetary value of their profits.
Let's include their initial investment in our calculations. Which portfolio will have better performance if their initial investments were €100,000 for portfolio A and €50,000 for portfolio B? Although they have made the same amount of profit, portfolio B shows a higher return because it made the €16,000 in profit with much lower investment.
Knowing the portfolio's return is important because it allows investors to track the performance of the assets throughout the years and to have a unified measure for comparison between their portfolio and others. You can also compare the success of your portfolio relative to risk-free instruments or portfolios, so you would know whether you have been adequately compensated for your risk level.
So, let’s look at the ways of calculating the portfolio return.
How to calculate return on investment
The complexity of the calculation of your portfolio's return depends on its composition. Also, changes in the cash flow will also spice up your calculation because you need to account for each cash inflow or cash outflow.
Estimating the performance can be simple if you hold only one instrument such as stocks from one company (all stocks are bought on the same day, the same price and under the same circumstances) and there are no additional investments or withdrawals. Here is how you can estimate the return on your portfolio:
Return = Ending value – initial investment / initial investment
For instance, you have bought €10,000 worth of stocks from company A on January 1, and their value by December 31 has grown to €12,300. Since this is the only security in your portfolio, the return can be calculated as:
Return = (€12,300 - €10,000 / €10,000) x 100
= 0.23 x 100
According to the above calculation, the investor has earned 23 per cent on the amount invested. However, this type of calculation of the return doesn't take into account potential dividend payouts or cash outflows from the investment. So, if you receive a dividend from your stocks, you can include this contribution in your calculations:
Return = (Dividend + (Ending value – beginning value)) / beginning value
Let's say that Company A from the example above has paid a dividend of €160 at the end of the year. In this case, the return will be different after accounting for the dividend and the return is calculated accordingly:
Return = (€160 + (€12,300 - €10,000)) / €10,000
= (€160 + €2,300) / €10,000
You can see that one way to measure the performance of an individual asset is to calculate its ROI or return on investment, where you divide the return generated by the cost of the investment (or initial capital).
But things become a bit more complex when your portfolio is composed of multiple types of assets. For estimating the return on such a portfolio you need to consider many different factors.
One way is to look at the return of each asset held and its respective weight in the overall portfolio. Here is how to calculate the weighted average rate of return on your portfolio:
Weighted average rate of return = w1x1 + w2x2 + w3x3 + w4x4 +………
"W" represents the weight of each asset while "x" means the return produced by each asset.
The weight of each asset is estimated by looking at the value of the specific asset divided by the total portfolio value. The sum of the weights of individual assets held in the portfolio equals 100 per cent or 1. Let's look at an example where the portfolio is composed of multiple assets with different individual returns and with different asset values. The table shows the portfolio composition and the respective return for each asset.
Knowing that the overall portfolio investment is €100,000 as well as the value of each holding, we can calculate the weight for each asset in the following manner:
Weight A = €30,000 / €100,000 = 0.3 (or 30%)
Weight B = €25,000 / €100,000 = 0.25 (or 25%)
Weight C = €45,000 / €100,000 = 0.45 (or 45%)
Consequently, the weighted average rate of return for the portfolio will be calculated as:
Portfolio return = 0.3 x 9% + 0.25 x 12% + 0.45 x 3%
= 0.027 + 0.03 + 0.135
= 0.0705 or 7.05%
The weighted average return earned by the portfolio is 7.05 per cent. This method can be used when you want to find the weighted average rate of return for a portfolio composed of two or more asset types.
When assessing the performance of your portfolio, you should distinguish between a total rate of return and the annualised rate of return. The former shows the return generated during the entire period, whereas the latter evaluates the average annual return.
Before you dive into calculating your portfolio's return, keep in mind that you need to gather all the relevant information, which depends on the selected performance measure. You would need to know at least the starting and ending value of your portfolio, the value of contributions (if any) and the value of withdrawals (if any). For simplicity, different types of fees and taxes were not considered in the calculations, but you should pay attention to these outflows since they can influence the overall return levels.
Every investor wants to know what is a good return on investment. However, there is no universal answer because "good return" depends on a variety of factors and it can be different for every person. A risk-averse investor can consider a 3 per cent return per year as a good return, while an investor willing to take a risk may consider a return in excess of 15 per cent to be good. So, it’s all about your personal preferences, the return generated by similar assets or portfolios, the degree of riskiness and other factors.
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