The investment world is a performance game. People invest in hopes of making money, to earn a good or satisfactory return on their investments (index, single stock, ETFs, portfolios, mutual funds, etc.).

Total returns reflect both capital/market gains or losses in the investment and income received from the investment. Income comes from the dividends paid by stocks and the interest or yield paid by bonds. Together, those capital returns and income returns make up total returns.

Example: The MSCI World Index earned a 24.4% total return in 2023. That was based on a 21.8% capital return (the amount the index appreciated during the year) plus a 2.6% income return (the total of the dividends the index received from its constituent stocks for the year).

According to investment industry conventions, total return numbers for periods longer than one year are typically represented as annualized returns. We can think of an annualized return as an average, except that it takes a compounding effect into account. In other words, it recognizes that if an investment made gains in the first year, then it has more to invest at the beginning of the next year.

As an example, at the end of June 2022 the MSCI World Index had a three-year annualized total return of 7.52%. The index investment never actually earned that exact amount in any year. But if one had bought the index at the beginning of July 2019 and hung on for the next three years, that´s what one´s per-year earnings would work out to be.

The total return number is calculated on the assumption that shareholders reinvest any distributions or payouts (income they receive from dividend-paying stocks or interest-paying bonds) that their investment makes.  

Putting Returns in Perspective

Imagine an investment that has gained an average of 10% per year for the past three years. If another investment is up 13% per year, the prior investment lags by three percentage points. However, this does not say much about its performance. To know how an investment is doing, one cannot look at returns in isolation; context is what matters. One needs to make proper apple-to-apple comparisons by using an appropriate yardstick such as an investment of the same or similar type, a comparable peer group (category) and an index to judge its performance.

An index is a group of securities and is the most common kind of benchmark. Investments should be compared with an index, sometimes more than one. How are they performing versus their peer group and relative to the relevant index, leading or lagging, outperforming or underperforming?

Which returns should one consider? How the investment did for the past 3 months, the last 10 years, or some period in between? Long-term investors should focus on an investment´s returns for the past 3, 5 and 10 years – even 20 years for retirement purposes. They should compare those returns with those of other investments in the same category to get a clear view of performance. There is no point in buying or holding an investment that is inferior for most periods.

Also take a look at the investment´s calendar-year returns versus its category and index. That is a handy way to identify an investment that may look good because of a couple of strong recent years, but a look at year-to-year calendar returns reveals that prior to its recent winning streak, the investment had been a terrible place to invest.

Finally, check an investment´s performance over several time periods, including its year-to-year returns to see how consistent or volatile its performance has been. I always prefer rolling returns over trailing returns, which will be the subject of future posts.