Mass media and many websites inform and chart securities' prices. Many outsiders believe that rising prices are the same as good performance, when it is not necessarily so.
Kinds of investment earnings
Stock, bonds and funds provide return in two ways simultaneously. The first is an increase in the securities' value. If a paper you hold currently costs $100 but you bought it at $80, then you have made a $ 20 profit. This return, called a capital gain, is the one that you can evaluate by looking at price. But that is not the full picture...
The total amount of value that investors earn from their investments, or, put in other words, capital gains plus distributions, is called total return
The second return-providing mechanism are regular distributions, also called ordinary income. Bonds, stocks and funds distribute cash monthly, quarterly, semiannually and/or annually.
Bonds do it in the form of coupons, which are the interest payments that the issuers bound themselves to make when they issued the paper. Many bond holders will see their assets keep a more-or-less constant price while their profits are achieved mainly through these distributions. They may make nice profits even with a declining price of the bond, if distributions are high enough. Therefore, these bonds are a clear example of why asset price is not the right measurement of performance.
Stocks also provide distributions, in their case of dividends. Every quarter in which the corporation has obtained profits, its board of directors decides how much of that money will be reinvested in the company (these are called retained earnings) and how much will be distributed among the shareholders.
Policies regarding how much to distribute differ between companies. They have to do with growth possibilities, economic climate and corporate strategy. Special cases are high-growth companies that retain all earnings, thus providing no dividends (for the time being). There are also trends in this respect, which can be seen in a graph of historical average dividend distributions for S&P 500 companies. As the graph shows, dividend rates for the last decade have been of about a 1.8% per year. This is significantly less than the interest rates of bonds, although stocks offer, in average, better returns, because they are more volatile and investors demand a premium in exchange for that uncertainty. Therefore, compared to bonds, stocks provide more of their return through capital gains, in average. Price is a better indicator of performance for their case, but still not a good enough one.
Funds also deliver cash regularly, because they distribute the coupons and dividends that their underlying assets pay. Moreover, there is an additional kind of distribution for funds, called capital-gains distributions, that are taken from the capital gains that the fund realizes when it sells assets that have increased in price. They are usually paid annually, near the end of the calendar year.
Total Return Defined
The total amount of value that investors earn from their investments, or, put in other words, capital gains plus distributions, is called total return. This measure is usually divided by the initial investment value and expressed as a percentage (strictly speaking, that result is a total rate of return, but many times the words rate of are not used). For example, a total return of 20% means that the investment has gained 20% of its original value, part of it through an increase in price and the rest through distributions of dividends (if it is a stock investment), coupons (if it is in bonds) and/or capital gains (if it is in funds). Therefore, total return is a good measure of performance. Not a perfect one, though, as is discussed in Limitations of Total Return as a Measure of Fund, Bond and Stock Performance.
It is useful to have a measure that is independent of investor behavior, so a commonly used definition of total return assumes that all distributions were reinvested
When a stock is held for a few months, until it pays dividends to the investor for the first time, investor's total return can be calculated straightforwardly, just by adding up the current value of the securities held (prices multiplied by stock held) and the dividends earned, dividing that result by the cost of purchase if we want to obtain a rate, and multiplying that result by 100 if we want it expressed as a percentage. What if the stock is held through several quarters? The total return would then depend on what the investor did with the dividends received. For example, if those distributions were reinvested fully, then total return would be higher compared to not reinvesting them.
It is useful to have a measure that is independent of investor behavior, so a more constrained definition of total return is often used, one in which it is assumed that all distributions were reinvested. This is a good definition for reflecting performance, because early distributions have a greater effect on the result than late ones, which is a desired property since early gains can be used by the investor to obtain further profits. Moreover, this way, if we accumulate the total return of each sub-period, the result will be the total return of the whole period, which wouldn't be the case if distributions were not reinvested.
Total return with distributions reinvested is thus a good measure of performance. It is frequently informed and charted in websites and publications, though not as often as price. Many times they use it as a synonym of performance. But it is still not perfect, as is discussed in Limitations of Total Return as a Measure of Fund, Bond and Stock Performance.
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