The return is the total income an investor gets from his/her investment every year and is usually quoted as a percentage of the original value of the investment. Usually the investor gets a return on his /her investment in shares or investment portfolio when they distribute dividends. The return on investment can be calculated by dividing the dividends the investor gets during the year on the total amount paid to buy the investment tool (shares, debt instruments, investment portfolio units). For example if a company distributed one riyal per share for its shares which are valued at 50 Riyals then the return on the share is 2% (1÷ 50 = 0.2 or 2%) . It is important to know the return ratio is fixed and does not change if the number of shares owned by the investor change.
Comparing Returns
Calculating the invested return allows comparing the percentages of the different investments in the investor’s portfolio returns. For example, the investor earned a return of 500 Riyals a year by investing 5000 Riyals in an investment portfolio and also earning a return of 500 Riyals from another investment in the amount of 25000 Riyals in some company. The investor will notice that the return of both investments is different as the return of the investment portfolio is 10 % (500÷ 5000= 0.1 or 10%) where the return of investment in the company’s shares us 2% only (500 ÷ 25000= 0.02 or 2%).
It is important to know that depending solely on comparing returns when making investment decisions is not the right thing to do. The return only calculates the income earned and not the growth in the market value of the share. For example, if the return on share (A) is 2% and share (B) is 4%; the assumption is that share (B) is a better investment while the reality is share (A) could be better if the company showed growth potential which means more opportunity for the shares to increase and eventually the return on investment would too.
Total Return
Calculating the total return takes into account the income achieved form the investment in dividends and any increase or decrease in the purchasing value of the investment. The total return can be calculated by adding these amounts together and then divide them on the invested amount.
Profits and losses
Capital profits are the profits the investor gains by selling an investment worth more than what was paid to buy it. Capital losses are the losses the investor bears by selling an investment worth less than what was paid to buy it.
Risk and Return
Understanding the relationship between risk and return is a very important and essential aspect to develop the investor’s investment strategy. To understand the relationship, there are three principles that the investor should always remember:
First: the relationship between risk and return is a direct relation. Whenever there is an increase in the risk to lose some of the invested capital, the possibility of a bigger return on investment is increased. Similarly, whenever there is a decrease in the risk to lose some of the invested capital, the possibility of a bigger return on investment is decreased. The fluctuation in investment or the short term price range is considered an important factor in determining the level of risk in investments and the increase in such fluctuations leads to increased risk.
Second: each investor has a limit to tolerate risk which is considered the standard to base on his/her investments in addition to his/her wealth and the available money to invest. The limits of risk toleration are a result of several factors such as age, the investor’s preferences (risk taker or not) and the investment goals.
Third: there are different ways to decrease risks as long as the risks differ along with the types of investments. The investor can balance between the risk and return in his portfolio by good asset allocation and by adopting a clear strategy to diversify the investments in the portfolio.