Investment 101: The difference between Price Returns and Rate of Return
Overheard…2 friends over a cup of coffee (fictitious)
A: “Hey, I invested $20,000. I just checked. The current value is $25,000. Good or not?”
B: Good! You’ve made $5,000.
A: “But my financial planner say it’s so-so only and he told me he is being diplomatic.”
B: What? 25% return not good enough? He must be crazy!
A: “But he told me it’s not 25%. It’s less than 1%.”
B: Your financial planner got license or not? Even my primary 2 daughter can answer that.
A: “Really! That’s what he told me. I’m confused.”
B: No problem! Let me ask my financial planner.
Whips out iPhone, goes to Safari and googles “$20,000 invested $25,000 returned. Good or not?”
B: Hmm…it seems my financial planner is a bit confused. Oh yah… need to ask one more question. When did you invest the money?
A: “Oh, I invested it 30 years ago”
Price Returns vs Rate of Return
It is one of the more confusing concepts when it comes to investments – The difference between Price Returns and Rate of Return.
Let’s do a test. Imagine you are a cash rich investor evaluating which investment option to take. Which of the following investments appear most attractive to you?
a. A property that tripled in value from $100,000 to $300,000.
b. Shares from company ABC which doubled from $1 to $2.
c. A unit trust that grew by 50% net of charges.
d. An account which pays a guaranteed fixed interest of 4%.
Have you decided?
What if I tell you that the property took 30 years to triple in value, the shares took 20 years to double in value and the unit trust took 15 years to grow 50%?
Which investment will you be choosing now?
Let’s take a step further. Consider the following:
a. A property whose value grew at 3.72%
b. Shares from company ABC whose value grew at 3.52%
c. A Unit Trust which grew at 2.74%
d. A savings account which gives a guaranteed fixed interest rate of 4%
It’s much easier to choose now, isn’t it?
What is Price Return?
According to Wikipedia, price return is defined as the rate of return of a portfolio, taking into account only the capital appreciation of the portfolio. In our everyday language, it means “How much did you make?”
When an investment is viewed as having made 20% or doubled in value, we are using price return. Price return has the unintended consequence of amplifying the understanding of numbers. This is one of the reasons why in marketing, price return is often used to grab attention in the headlines.
What is Rate of Return?
On the other hand, Wikipedia defines rate of return as a profit on an investment over a period of time, expressed as a proportion of the original investment. Put simply, how much are you making a year?
When we read that the CPF Ordinary Account pays an interest of 2.5%, this is known as the rate of return. If it’s calculated based on a year, we can call it the annual rate of return or if it’s over a number of years, the compounded rate of return.
Using the rate of return has the opposite unintended effect as opposed to Price Return as it makes the numbers look underwhelming. However, if you are an investor with a long term view, this is the right benchmark to evaluate your investments.
Making sense of the Numbers
There is a very practical use to understanding these concepts. The next time you read a headline about an investment that grew by 50% since its launch, you should take a step back and ask “What is the rate of return?”. This may prevent you from being attracted to what you presume to be a high performing investment but in actual fact, it has barely been able to perform beyond inflation rates.
On the other hand, you may be promised credit lines or loans at “low interest or borrowing fees”. You should ask what is the total amount of interest payments before deciding if it’s “low”. After all, the credit card interest rates were never marketed as “Double your debt in 3 years” but most probably as “2% a month”.
Now, that makes sense!
Article by Lee Meng Choe
The writer is the Executive Director (Distribution) of GEN Financial Advisory