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What constitutes a return on a single asset? How is it calculated?
The typical reason for an investor to invest in a financial instrument is to make current income from dividends and interest income. For a stable company, the investments will earn a reasonable return that is the Expected Rate of Return (ERR) on given investments. Some investments such as debentures, bank deposits, public deposits, bonds, etc. carry a predetermined fixed rate of return that is usually payable periodically.
Note − The sole aim of the investor investing in a single asset is to get the maximum returns. Some fixed income instruments offer less returns, but they are less risky too. Increasingly risky instruments offer higher returns.
In case of investments in company shares, there is no assurance of periodical payments as dividends, but it often offers higher returns than the above-mentioned instruments. Investing in the shares of companies have higher risks than fixed income instruments.
Another form of return available is in the form of capital appreciation. This return is the gap between the real purchase price and the price at which the asset can be sold, this can be a capital gain or capital loss for changes in the given market price of the shares.
The yearly rate of return can be calculated as follows −
$$\mathrm{R=\frac{D_{1}}{P_{0}}+\frac{(P_{1}-P_{0})}{P_{0}}=\frac{D_{1}+(P_{1}-P_{0})}{P_{0}}}$$
Where,
R = Yearly rate of return of a share
D1 = Dividends declared at the end of the year
P0 = Market price of share at the start of the year
P1 = Market price of share at the ending of the year
The above formula is used for determining the annual return of an investment in shares. Here,$\frac{𝐷_{1}}{𝑃_{0}}$represents the dividend yield. It is notable that the term in parentheses in the numerator of the above-mentioned equation gives the capital gain or loss.
When the price of the security at the end of the given period is higher than that at the beginning, then there is a "capital gain". On the other hand, if the ending price is less than the beginning price, then there is a "capital loss".
Note − Even though there is no capital gain/loss until the security is not sold, it should be taken into the calculation while determining the return on investments.
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