How do investments make money?
Investments can generate returns in three ways: They are:
Earning interest: This is income generated on any kind of debt-based investment as compensation for loaning a principal amount to a borrower or issuer. This type of income is commonly paid by fixed income securities such as guaranteed investment certificates and bonds.
Receiving dividends: Some companies may pay dividends. Dividends are a payment from the company to its shareholders from the profits earned. It may be paid out on either a monthly, quarterly or annual basis.
The dividend payout is based on the number of shares owned by the shareholders and this can be reinvested. A crucial feature is that the payouts can generally be raised, lowered or discontinued at the discretion of the company’s board of directors.
Capital gains: This income is generated when an investment that has increased in value is sold. For example, if you bought a share of a company at $20 and the share price rose to $27 and then you sold it, you would realize a capital gain of $7.
It’s important to remember that returns are all taxed differently. Taxes can be based on the type of account (ie. unregistered and registered) that you hold them in, as well as the applicable tax laws from foreign countries where your investment is issued from.
Return on your investment
Return on investment (ROI) or rate of return is the approximate measure of an investment’s profitability. Investment performance reports include the rate of return for your investment portfolio.
Your personal rates of return are calculated based on the changes in the market value of your investments within your account and more specifically to the timing and amount of your deposits, withdrawals, purchases and sales.
Common methods of measuring investment rate of return
Calculating the rate of return of your investments is an important step in understanding if you are successfully tracking towards your financial goals within your time-horizon.
Three common methods investors can use to calculate the rate of return of their investments over a given period of time include simple rate of return, time-weighted rate of return and money-weighted rate of return.
Under securities laws, registered advisors, firms and trading platforms must disclose returns annually using the money-weighted rate of return method.
Simple rate of return: Using the simple method, investors can calculate how their investment has done over a period of time. This calculation takes into consideration the investment’s current value minus its initial value and fees. This method can give you a basic view of your investment return but ignores cashflow movements like contributions and withdrawals, which can change the rate of return percentage dramatically.
Time-weighted rate of return: The time-weighted method is often used to minimize the impact caused by deposits into and withdrawals from your investments. In this method, the rate of return on an investment is divided into individual sub-periods based on when money was deposited and withdrawn. Each sub-period is given equal weighting, and returns are calculated by multiplying returns of individual sub-periods to show the overall compounding effect.
This method is usually used to assess the performance of a portfolio or investment independent of the size of the contributions or withdrawals made by an investor. Investment managers or advisors often opt for this method to showcase their performance in selecting investments for their clients’ portfolios.
Money-weighted rate of return: Building on time-weighted, money-weighted rate of return calculations takes into account the timing and size of an investor’s deposits and withdrawals from an investment. This is considered by many to be the most comprehensive view of rate of return as it factors in an investor’s behaviour over time.
Depending on what aspect of your investments you want insight on (ie. overall returns, investment performance, or dynamic investment performance), investors can use any one or combination of these rate of return calculations.
