Talking Money: Total Return
By Paige Radke
When stock and bond prices are declining, it is easy to focus on the falling prices and forget about the importance of income. That is why long-term investors need to measure performance through total return.
Total return represents how much an investment has actually made for an investor by accounting for both capital appreciation and income. Capital appreciation is the rise in an investment’s value based on its market price. Income is money investors receive through dividends, interest and other distributions.
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Dividends are a piece of a company’s profits distributed to shareholders. While not all companies pay a dividend, those that do show financial health and confidence in future business operations. Dividends are often expressed as a yield representing the dividend income per share divided by the stock price per share.
Interest is the money an entity pays out at a particular rate for money it borrows from investors. It is the income that investors generate from investing in the bond market.
In stocks, capital appreciation often outweighs income. With bonds, income and price stability are the primary goals.
Examining returns in the context of both capital appreciation and income is critical to long-term investing. From 1926 to 2012, dividend income has represented more than one-third of the total return on the S&P 500.
Additionally, in years when the stock market is down, the dividend component can generate positive total returns. For instance, in 1994, the S&P 500 fell 1.54%, but a dividend yield of 2.86% generated a positive total return of 1.32%.
Dividends also explain why value investing outperforms growth investing in the long-term. From 2002 to 2014, looking solely at capital appreciation, growth stocks outperformed value by 3%. However, when you factor in the income generated from dividends to get total return, value outperformed growth by a whopping 32%.
Total return for bonds is important to remember particularly in times of rising interest rates. Higher interest rates cause bond prices to go down, lowering the share price of bond funds.
However, the change in price does not change the interest paid out in a given year. So, even if bond price goes down, the income generated through interest can produce a net positive return. In 2003, for example, government bond prices fell 3.26%, but an income return of 4.80% resulted in a positive 1.45% total return.
Whether investing in stocks or bonds, long-term investors should remember that their return comes not simply from price movements but also from the income their investments generate. When prices drop, consider the income you are receiving. It may outweigh the price change, especially in the long run.
Paige Radke is an associate at Landaas & Company.
(initially posted Dec. 22, 2015)