Risk and Returns

Return

The word return is used in many ways in finance. For a start we might mention cash return, return on capital, and overall return. In these contexts, return will be measured as a percentage of the amount invested. To keep things simple, we shall, in all that follows, refer to yearly return, i.e. the amount earned over the course of a year on some sum invested at the beginning of the year. Imagine that you purchase 1 share of XYZ Corporation for $100. During the year, the corporation pays out dividends totaling $5.00 per share. Your cash return in this case would be 5%, i.e. 5/100. Your return on capital would depend on the price of the stock at the end of the year. If, for example, the price of XYZ were to rise to $110 by the end of the year, you would have realized a gain of $10 in capital appreciation, i.e. a 10% return on capital. Overall return is just the sum of the cash return and the return on capital, in this case a total of 15%. If, on the other hand, the price of XYZ had declined to $90 during the year, resulting in a loss of $10 per share, your return on capital would be -10%, for an overall return of –5%.

While we have chosen shares of stock for our example above, the concepts are appropriate for any asset that we might purchase or own. The interest paid out on bonds would be a cash return, while the return on capital would depend on the change in the market price of the bond during the year. Should we invest in real estate, the net income (gross rents less expenses) would be the cash return, and the change in the market value of the property would lead to the return on capital. An investment in old master paintings might lead to a cash return if we were to charge for exhibiting the paintings, and a return on capital when we sold the paintings. Cases of fine old Bordeaux would not likely yield a cash return, but would certainly be expected to rise in price over time, yielding a return on capital (assuming we don’t drink the wine first)....