Econ Grapher

Return (return on investment)

What is a Return?
Return is what you receive on an investment as a reward for supplying capital and bearing risk. Return is also referred to as reward, rate of return, return on investment (ROI), yield, gain, etc. When people refer to return or return on investment they almost invariably mean the rate of return. The rate of return divides the dollar amount of reward by the dollar amount invested; this is essentially a way of standardizing the return received on an investment to the size of the investment and allows returns to be compared across asset classes and within asset classes. A rate of return is similar in concept and function to an interest rate on a deposit, but often a rate of return e.g. on a stock, is more of a performance metric than a contractual rate.

How does it relate to Markets?
Return is a key concept in markets, it comprises part of the fundamental risk-reward trade-off (which is discussed below), and forms the basis for participation in markets. Firms that need access to capital will provide a return or potential return to investors in exchange for offering capital (e.g. interest for debt capital, and capital appreciation and dividends for equity capital). Likewise people with capital to invest who require higher rates of return will look to investments available in e.g. the stock market in preference to less risky, but lower yielding investments. Return is also a critical concept to understand for those who are investing, it is the ultimate indicator of investment performance - i.e. 1. did you make money? 2. how much money did you use to make the money? 3. did you beat tax and inflation? The last point is worth noting, the "real return" is the return you get after deducting tax and inflation, because if you aren't beating these then you are going backwards (likewise you may also need to include fees and other direct expenses).

Calculation
In it's simplest form, holding period return is the total proceeds at time 1 divided by the total investment at time 0. For example you invest $100 into Goldman Sachs; buying one share and then a month later the price rises and the share is now $112, the return at this point is 112/100 = 12%. Of course you will need to factor in the receipt of dividends and any amounts invested in addition to the initial amount. You can also calculated the compounded rate of return (which is important to do if you are considering a multi-year return, to see how good it really is): price in year x divided by price in year 0 to the power of 1 divided by the number of compounding periods e.g. years. As an example: you buy the one share in Goldman Sachs again for $100, in 4 years the price is now $180; this equates to an 80% return, but over 4 years; the compounding return is: (180/100)^(1/4)-1 = 15.83% which would still be a respectable return, but you really need to think of returns in this way - especially if you are looking to benefit from the magic of compounding growth. 

Risk and Return trade-off
The risk and return trade-off is one of the core concepts of finance and investing, it says that whenever you make an investment you are taking on risk; there is the risk that you may not get all (or any) of your investment back, there may also be risk in the amount of return you get e.g. in the case of stocks the return is potentially unlimited, but then of course you could end up losing all of your investment if the company went bankrupt... contrast this to US government debt; the US government has a reasonably strong standing as a borrower, and pays basically the lowest rate in the US, but you can pretty much count on the payments coming in (vs e.g. a company who may fall behind on their payments if they get into financial difficulty). So the point is that every investment has an element of risk to it - the key is whether the potential reward/return is high enough to compensate you for this... the right mix will come down to things like personal preferences, investment time horizon, and portfolio optimisation (see also in risk: Sharpe ratio, Beta, Alpha).

Sources and further reading:
Value Based Management.net - Return on Investment ROI
Investopedia - Real Rate of Return
Economy Watch - ROI, Return on Investment
Retail Investor .org - Understanding Rates of Return

Graph Library:
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Original Source: http://www.econgrapher.com/encyclopedia-return.html

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