Investments Returns and the 4 Most Common Measurements

 

Types of Returns

There are two key return measure of your apartment. 1) Increase of its value which is called capital gain in general, and 2) from rental income which can be from dividends or interest payments.

Just to clarify the second point, dividends payment is a term referred to the amount distributed from the asset income (or apartment income in our example). The interest payments generally refer to income generated out of money, for example a bank loan (you pay interest for the money you received) or a bank fixed deposit (they pay you interest for the cash you deposited).

 

Now what are the methods we can use to measure our returns?

Type of Return Measurements

Let us start with another example, John has bought a house for one million dollar and after five years he sold the house for one and a half million. throughout these five years he had been receiving income from rent as well.

The different methods he can calculate his returns through:

Holding Period Return

Is the measure of returns for a specified period. in the case of John example, he may want to know his overall income and house value that he made over the five years. Holding period return is the method he should use, it answers the question “How much money I made from my house since I bought it and until I sold it today?”. This method is finds the end value and income increase in comparison to the beginning value.

Some people would consider the above method enough for their measurement, they just want to know how much they made.

Others would want to know how much money they made every year (annualised basis). This is where the other three methods are relevant. They are ideal for calculating averages and weight in returns usually on an annual basis. They answers the question “So how much I make every year from my house on average? What about my cash? I want it early”. If you find it confusing just keep reading hopefully it gets more clear :).

Arithmetic or Mean Return

Calculates the average return of an investment. It is the basic average calculation we usually use. The total returns divided by the number of years, another example is the total score of students in a class divided by the number of students.

Lets think about arithmetic mean for a moment, if we say that John received substantially higher income in the second year of his five years because of a generous tenant who won a lottery or something. The average calculation result would be influenced by this amount and increase the average to a higher than usual amount.

So how can John have a better representation of his average annual returns? he can either adjust the amounts by changing each period figures or just use the geometric mean specially if there was much fluctuations in his rental.

Geometric Mean

This method takes into account the accumulated annual return. Instead of allowing the fluctuations in one year return or more influence the overall performance it minimises its impact and makes the average returns more smooth and a better representation of the house rent performance. You may think, how can geometric mean make more smooth returns with less fluctuations? you will notice in the calculation of this method it includes square rooting the figures. Doing that it minimise the impact of large figures.

Usually geometric mean method is a better performance measurement of an investment because it gives an insight of the closest possible return they can get every year on average without exaggeration in either the positive or negative returns.

However, sometimes there are cash flows movements throughout the investment period that also have impact. Let us say John decided to take the full rent out for one year without doing maintenance and the next year he have spent more money to do house maintenance twice. How can we measure his return if the cash is moving like that?

Measuring the performance now would not be relevant because in reality if you receive your cash early you can invest it elsewhere and make more returns and vice versa, if you receive the money late you will miss out in returns. Here is where money weighted method comes to place.

Money Weighted

It is all about the cash flows. This method calculate the return with focus on the timing of cash flows whether it is received or paid, this method is also referred to Internal Rate of Return or IRR.

It is usually used when there is an investment manager managing the money and want to maintain a certain rate of return to their investor. unlike the other methods the calculation is the opposite of the other methods we looked at. For IRR we usually have a targeted rate of return or can be referred as discount rate and we change the cash flows to adjust to the desired percentage.

From another angle, if the investor received his money earlier it means that he have generated more returns, because he can easily take this money and reinvest it back in another investment and the opposite way around, if he received his money late he will not be able to generate the additional returns.

Here comes our last example, John asks his property manager that he wants rate of return of his house to be 8% annually. The property manager can use the money weighted return method to show a timeline for John on when he will receive his money allowing him to take advantage of utilising it earlier and also at the same time the property manager will have a clear spending plan on maintaining the property effectively. This method will help both John and the property manager to plan their cash flows and both be happy.

 

Why All these Methods?

You can view these methods as tools under your belt for handling different situation whenever necessary. Some would want to know the end story “How much money will I make at the end of this period?” so they will use the holding period return. Other person would ask “how much would this investment make me every year?” then the geometric mean is ideal. That is what is interesting about it, you can utilise the methods you have to measure your investment returns from different angles. What do you think? which is the most reasonable measurement tool?

Well that’s all, please let me know if you want us to further discuss each method separately in details or if you have any idea and suggestion please leave a comment below. For now, have a great day :)!

 

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