The Total Rate of Return

Sponsored Link

When saving or investing, be it in a bank or building society savings account, or in stocks and shares it is important to establish how you want to achieve a return from that investment. In addition, what the total return might be, as this will determine the level of risk you are prepared to take. The higher the risk, the higher the rate of return you should expect on your capital invested.

An investment in a building society account will generate interest on the amount saved, with the amount being added to the balance on a periodic basis. Some savings accounts pay an annual rate of interest, whilst others pay more frequently, say on a monthly or quarterly basis. Interest rates quoted for monthly or quarterly interest will typically be lower than annual rates. This is because it can be compounded or accrued over the year, so if comparing accounts look at the annual equivalent rate or AER to get a true picture.

With a bank or building society account, the value of the initial capital investment does not increase. The balance itself will only rise due to further investments made or by the re-investment of interest into the account.

The percentage rate of return will be easy to see as it will be advertised by the building society, but is calculated by dividing the interest received by the balance in the account. This is known as a basic rate of return.

An investment in equities on the other hand will usually give rise to a dividend, on a periodic basis, in a similar way to bank interest. However dividends on ordinary shares are not guaranteed and fluctuate from year to year depending on profitability and the reinvestment requirements of the company.

If you would prefer to receive your gains by way of a dividend, to give you an income in retirement for example, look for income stocks. These will pay a relatively high dividend and are in sectors such as utilities and insurance.

Other stocks are more focused on capital appreciation, particularly if they are growing companies with expansion plans, and will tend to pay little or no dividend. This is often the case in the early years of a cmpany?s life. Examples of such stocks are found in the information technology sector.

The basic rate of return on ordinary shares is known as the dividend yield. This is calculated by dividing the dividend received by the price of the share.

The price of the share can go up or down for a whole host of reasons, be they company specific, macro-economic or just market sentiment. Markets also tend to follow the sentiment of other countries. This is most apparent when the US market falls as the UK market tends to follow suit almost immediately. Assuming the share price does increase, this will generate a capital return.

The basic return or income return and the capital return together give the total rate of return. It is this return that should be considered when making investment decisions and determining whether the rewards are worth the risks.

Individual circumstances always play a part and it isn?t just the ?how much? but also the ?how?. That is, do you want the gains to take the form of income or capital? Also what are the tax implications of generating such returns?

---

Carl Fletcher writes for the Indexed Results network including the Business Axis Directory.