'Return' is the fundamental measure of investment performance

Are you sure you understand 'interest'?

Income return

If you deposit £100 for a year at 3% interest you will get £103 back. This is your £100 deposit (' principal') and £3 of interest ('income').

You might look on the £100 as an investment - putting money away to get more back in the future. The £3 could then be called the 'return on the investment', or, in short, a '3% return'. It is also a 3% income return.

Capital return

If you buy a gold coin for £100 and sell it a year later for £103 you have again made a 3% return. This time you have made this money through capital appreciation. So it is called a 'capital return'. But it's £3 just the same.

Total return

If you invest £100 in a share and it pays a dividend of £3 and also goes up in value to £102 you have made a total of £5. Cleverly, this is called the 'total return', or just 'return'. As an investor, you do not care about the separate capital and income returns (except for tax reasons). You just care about your total return.

Get used to adding your income return (or 'interest' or 'yield' or 'dividend') to your capital return (or 'capital gain') to get your total return. In the example, 3% + 2% = 5% total return.

Multi-year returns

If your £100 goes to £105 in year 1 and to £115.50 in year 2, a bit of maths tells you that you made 5% in year 1 and 10% in year 2. (10% of £105 is £10.50).

There's a way of reducing this information to a single 'annualised return' or 'annual return'. In this example you have made a return of 15.5% over 2 years. This is equivalent to 7.47% per annum compounded (not 7.5%, which would be simple interest). You would refer to your investment as making an 'annual return of 7.47%'. If you want to understand the maths (which is not necessary) google on 'compound interest' or wait for the next module (below). If you chose bigger numbers, or mix positive and negative returns, the difference becomes more exciting.

As you may guess, it is possible to calculate an annual return from any old mish-mash of cash flows over any period. The 'annual return' for this mish-mash is called the 'Internal Rate of Return (IRR)'.

All other things being equal, you want the highest possible returns from your investments. To put it another way, you want the highest possible IRR.


Learn about 'Compounding' now: