Retirement plan decisions made easy
Drill Down: Investment Returns
Investment returns include two major components: current income and price appreciation. For a bond or bank account, current income is the interest.
Price appreciation—which can also be price depreciation—is the second element of return. Some assets don’t fluctuate in value. Your savings account at the bank is a good example. Most investments, however, can go up or down. Even risk free government bonds can go up or down in price. (I’ll explain how that happens later.)
Both income returns plus appreciation are calculated as a percentage of the asset’s value. Let’s use an example.
- January 1: you own 100 shares of ABC stock that are worth $20 per share.
- Every three months, you receive a dividend of ten cents per share. At the end of the year, your dividends total $40 (10 cents a share, times four times a year, times 100 shares).
- December 31: your shares are now worth $22 per share.
Your total return has two components:
- Dividends came to 2.0 percent of your starting value. (Starting value was $2,000, equal to 100 shares at $20 per share value. Total dividends paid were $40. Dividing $40 by $2000 yields 2.0 percent.
- Price appreciation was 10.0 percent. (The price increased from $20 to $22, a gain of two dollars.) Two dollars is ten percent of the initial value of $20 per share.
- Total return was 12 percent, comprised of two percent income and ten percent price appreciation.
If you’re into mathematics, we can jazz up the arithmetic. Over longer time periods, we usually assume that when dividends were received, they were immediately reinvested in the stock. At the end of the time period for which you own the stock (called “the holding period”), you simply compare your stock’s end value with its beginning value. Going forward, we don’t know what our investment returns are going to be. Will our stocks go up or down? Will the company that issues bonds be able to pay the principal and interest on time? We’re never really sure, so we have to rely on some rough guides. We learn what usually happens from history, but we confirm these conclusions with logical analysis of what “should” be happening, to make sure that we are not just seeing a weird aberration that won’t be repeated.
As a general rule, stocks get most of their returns from price appreciation. In fact, some stocks don’t even pay any dividends but still manage to have good total returns.
Bonds tend to pay out most, or all, of their returns as current income in the form of interest payments.
Money market mutual funds almost always have no price change, so all return is current income.
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Lesson 1: What the Heck is a 401k, and What’s So Great About It?
Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
» Lesson 4: Investments: How Investments Work
Lesson 5: Loans and Hardship Withdrawals from Your 401k
Lesson 9: Your 401k, Your Other Assets, and Your Life
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