TOTAL RETURN: Don’t Focus Solely on Price Change

Dollar up downHumans, especially those of us “number people”, are wired to focus on price change. And when it comes to investments, price change is certainly a gauge of how an investment is doing. But is it the only factor? Absolutely not.

Price change is just one-half of the components that dictates total return. Here’s the formula you need to know when it comes to performance:

TOTAL RETURNPRICE CHANGE + YIELD

What this means is that Total Return equals not only the return on investment due to price appreciation/ depreciation but also due to reinvested dividends or income. Frankly, price change alone can be a really poor gauge of how an investment is doing particularly one with regular distributions such as bonds. So, let’s talk about bonds.

We’ve discussed the inverse relationship between rising interest rates and bond prices before. Assuming the economy continues to heal and rates continue to rise, bond prices will go down on paper. In that case:

?

=

+

?

TOTAL RETURN

=

PRICE CHANGE

+

YIELD

We still don’t know what that does to total return. But let’s say we have a bond yielding 6% then we know:

?

=

-?

+

+6

TOTAL RETURN

=

PRICE CHANGE

+

YIELD

If the yield is bigger than the price change, then total return is still positive. As I mentioned in my last quarterly market commentary, a bond typically will lose 1% in price for every year of duration that it has left for every percentage point rise in interest rates. Hence, let’s assume a one-year time frame and if interest rates go up 1% for a fund that has 4 years of duration (meaning time to maturity) with a 6% coupon, then we know:

+1

=

-5

+

+6

TOTAL RETURN

=

PRICE CHANGE

+

YIELD

Even though the price went down 5%, the total return on the investment was actually up because of the positive-ness of the investment’s yield.

So don’t get caught up in just one part of the formula, folks. Total return is what matters.

BTW, this doesn’t only apply to just bonds. Yield (in the form of dividends) make a difference to equities as well.

Did you know that the S&P 500 has gained +9.8% per year over the last 50 years (1963-2012) on a total return basis? If you remove the impact of reinvested dividends, the raw index is only up +6.4% annually, HENCE dividends make up 35% of the index’s total return in the last half century. Wow!

(source: BTN Research)