When you evaluate alternative investments for inclusion in your portfolio, you often compare investments with widely different prices or lives. For instance, one might want to compare a R600 share that pays no dividends to a R3,000 share that pays dividends of R50 a year. To properly evaluate these two, you must accurately compare their historical returns. Here, we tell you how to properly measure the rates of returns.
When we invest, we defer current consumption so that we can consume more in the future. Therefore, when we talk about return on an investment, we are concerned with the change in wealth resulting from it. This change in wealth can be either due to cash inflows, such as interest or dividends, or caused by a change in the price of the asset (positive or negative).
Holding period return. The period during which you own an investment is called its holding period, and the return over the period is the holding period return (HPR). So, if you commit R20,000 to an investment at the beginning of the year and you get back R22,000 at the end of the year, what is your return? Here, the HPR is 1.10, calculated as follows: HPR = ending value of investment/beginning value of investment, i.e., R22,000/R20,000= 1.10.
This value will always be zero or greater?that is, it can never be negative. A value greater than 1.0 reflects an increase in wealth. A value less than 1.0 means you suffered a decline in wealth, which indicates you got a negative return. A HPR of zero indicates you lost all your money.
Holding period yield. Although HPR helps us express the change in value of an investment, investors generally evaluate returns in percentage terms on an annual basis. This conversion makes it easier to directly compare alternative investments that have markedly different characteristics. The first step in converting HPR to an annual percentage rate is to derive a percentage return, referred to as the holding period yield (HPY). Here, the HPY is 10%, calculated as follows: HPY = HPR-1 ; 1.10-1.00 = 0.10, i.e., 10%.
Annual holding period yield: To derive an annual HPY, you compute an annual HPR and subtract 1. Annual HPR is found by: Annual HPR = HPR1/n, where n = number of years the investment is held.
Let us take an example. Consider an investment that cost R20,000 and is worth R25,000 after being held for two years, the HPR is 1.25.
HPR = Ending value of investment/Beginning value of investment. R25,000/20,000= 1.25
Annual HPR = 1.251/2 = 1.118 and annual HPY = 1.118-1= 0.1180, i.e., 11.80%
The ending value of the investment can be the result of a positive or negative change in price for the investment alone (e.g., a firm’s share price is going from R200 to R220), income from the investment alone, or a combination of price change and income. The ending value includes the value of everything related to the investment.
Holding period return is an essential and basic way to measure how much return you got on a particular investment. This computation is on the basis of per rupee of the amount invested, instead of time, which makes it difficult to compare returns on different investments with different time windows. While making such comparisons, the individual investor should use annualised calculations as discussed above, which is of a scientific nature.
* The writer is associate professor of finance and accounting at IIM Shillong
