When it comes to investing, even intermediate investors may get confused with the difference between interest earned and returns gained.
Most investors are seeking to achieve two primary objectives: to protect their original capital and to earn a surplus on top of their initial investment. This surplus is known as a return, and it is often expressed as an annual percentage rate of return, which allows for easy comparisons between different types of capital assets. In this article, we will explore the concepts of interest and return, and how they relate to investing.
Return is the amount of profit or loss an investor earns from an investment as it rises or falls in value (capital gain). Return can be calculated as using just the capital gain or loss or it can be classed as a total return, where the income (e.g. interest from a bond or dividends from a stock) is also included.
Stocks and funds are an example of investments that provide returns in the forms of both capital gains and dividends. When you invest in stocks capital gains occur when the stock price increases, while dividends are payments made to shareholders out of a company's profits. If an investor bought a stock for $100 and sold it for $120, they would earn a capital gain of $20. If the stock also paid a dividend of $2 per share, the investor's total return would be $22. Alternatively, if the stock sold for only $80 with a dividend of $2, the investor would still have a loss of $18 despite receiving dividend payments. It is important to note that while dividends can be enticing when considering a stock or fund, they are not the same as interest and are not guaranteed. It is the company’s choice to change or pay dividends to its shareholders and the amount/frequency of dividends often depends on performance, objectives, and market conditions.
Interest is a form of return, typically calculated as a percentage of the amount originally deposited, loaned, or borrowed. It is a form of income earned by lenders and depositors. For example, if you deposit $1,000 into a savings account that pays 2% interest per year, you will earn $20 in interest over the course of the year. Interest can be calculated in various ways, such as on an accumulating balance, where interest is added to the principal balance over time, or on a reducing balance, where interest is paid off over time.
Interest rates can be fixed or variable. A fixed interest rate remains the same throughout the life of the investment or loan, while a variable interest rate can fluctuate based on market conditions or other factors. The interest rate you receive will depend on several factors, including the type of investment or loan, the length of the investment or loan term, and your creditworthiness.
An example of fixed interest is interest earned from bonds. Bonds are debt securities issued by companies, municipalities, or governments. They pay a fixed rate of interest, also known as a coupon, for a set period. When the bond matures, the investor receives the principal back. For example, a bond with a face value of $1,000, a coupon rate of 5%, and a maturity of 10 years would pay $50 in interest each year. While they are considered a conservative investment it is still possible to experience a negative return on a bond. This can arise from selling your bond before its maturity. Inflation can also erode the purchasing power of bond returns over time, leading to negative real returns when the inflation rate rises above the coupon rate.
External Factors Affecting Interest and Return
Interest rates and returns can be influenced by a variety of factors, including economic conditions, market trends, and government policies. For example, during periods of economic growth, interest rates may rise as demand for credit increases. On the other hand, during a recession, interest rates may fall as the central bank tries to stimulate economic activity.
In addition to macroeconomic factors, individual investments can also be impacted by company-specific factors such as financial performance, management changes, and industry trends. It's important for investors to research and understand these factors when making investment decisions.
Conclusion
When investing, it's important to consider the total return on an investment, rather than just the interest rate or dividend yield. For example, a stock may pay a high dividend yield, but if the stock price declines significantly, the total return may still be negative. Similarly, an investment with a lower interest rate may offer a higher total return if it has strong potential for capital gains.
Understanding these concepts and doing proper research can help investors make informed decisions and achieve their financial goals.
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