Understanding Investment Returns: Definition and Examples

When it comes to investing, understanding returns is crucial. Returns represent the profit or loss derived from investing or saving. They are a key metric used by investors to assess the performance of their investments and make informed decisions. In this blog post, we will explore the definition of investment returns, different types of returns, and provide real-world examples to illustrate their importance.

What Is a Return?

A return, in the context of finance, refers to the profit or loss obtained from an investment or saving. It represents the financial gain or loss realized over a specific period of time. Returns can be positive, indicating a profit, or negative, indicating a loss.

Understanding a Return

Investment returns can be measured in various ways, depending on the context and the type of investment. Some common measures of investment returns include:

• Nominal Return: The nominal return is the percentage increase or decrease in the value of an investment without accounting for inflation. It is calculated by subtracting the initial investment amount from the final investment amount, dividing the result by the initial investment amount, and multiplying by 100.
• Real Return: The real return adjusts the nominal return for inflation. It provides a more accurate measure of the purchasing power gained or lost from an investment. The real return is calculated by subtracting the inflation rate from the nominal return.
• Return Ratios: Return ratios, such as Return on Investment (ROI), Return on Equity (ROE), and Return on Assets (ROA), are used to assess the efficiency and profitability of an investment or a company. These ratios compare the return generated with the amount of investment or assets employed.

Examples of Investment Returns

Let's consider a few examples to understand how investment returns work in practice:

Scenario 1: Samantha's E-commerce Business

Samantha invested $10,000 in her e-commerce business. After a year, her business generated a profit of $2,000. To calculate her nominal return, she subtracts the initial investment ($10,000) from the final value ($12,000) and divides the result by the initial investment. Her nominal return is 20%. However, when she accounts for inflation, which was 3% during the year, her real return becomes 17%.

Scenario 2: Mario's Pizzeria

Mario invested $50,000 to open a pizzeria. In the first year, his business generated a profit of $10,000. Mario calculates his nominal return by subtracting the initial investment ($50,000) from the final value ($60,000) and dividing the result by the initial investment. His nominal return is 20%. Considering the inflation rate of 2%, his real return becomes 18%.

Scenario 3: Mike's Freelance Video Editing Work

Mike earned $5,000 from his freelance video editing work. He invested $2,000 in upgrading his equipment and spent $500 on software subscriptions and other expenses. To calculate his ROI, he subtracts his total expenses ($2,500) from his earnings ($5,000) and divides the result by his total expenses. His ROI is 100%.

Impact of Diversification on Returns

Diversification is a strategy used by investors to reduce risk and potentially increase returns. By investing in a diverse range of assets or securities, investors can spread their risk and mitigate the impact of poor-performing investments. Diversification can lead to improved risk-adjusted returns, as losses in one investment can be offset by gains in another.

The Bottom Line

Investment returns play a critical role in assessing the performance of investments and making informed decisions. Understanding the different types of returns and how they are measured is essential for investors. By analyzing returns and considering factors such as inflation, risk, and diversification, investors can make more informed investment decisions and work towards achieving their financial goals.