What investment returns are possible?

Figure 13.1 shows the long-term rates of return on some popular investments. When people invest their money, they take a financial risk (also called business risk) namely, the possibility that the investment will fail to pay them anyreturn to the investor. Later in the chapter, investing poses a number of other kindsof risk. At the extremes, a company could have a very good year earning a considerable profit, or it could go bankrupt, causing investors to lose all of their money.

Investors hope that their investments will earn them a positive total return, which is the income an investment generates from current income and capital gains. Current income is money received while you own an investment. It is usually received on a regular basis as interest, rent, or dividends. As we have noted elsewhere in the text, interest is the charge for borrowing money. Investors in bonds earn interest. Rent is payment received in return for allowing someone to use your real estate property, such as land or a building. A dividend is a portion of a company’s earnings that the firm pays out to its shareholders. For example, Nina Hernandez from Oneonta, New York, purchased 100 shares of H&M stock at $45 per share ($4500) last year. The company paid dividends of $3 per share during the year, so Nina received $300 in cash dividends as currentincome.

A capital gain occurs only when you actually sell the investment; it results from an increase in the value of the initial investment. It is calculated by subtracting the total amount paid for the investment (including purchase transaction costs) from the higher price at which it is sold (minus any sales transaction costs). For example, if the price of H&M company stock rose to $52 during the year, Nina could sell it for a capital gain. If Nina paid a transaction cost of $1 per share at both purchase and time of sale, her capital gain would be $500 [($5200- $100) ($4500 + $100)].

Capital losses can occur as well. For most investments, a trade-off arises between capital gains and current income. Investments with potential for high capital gains often pay little current income, and investments that pay substantial current income generally have little or no potential for capital gains. Longterm investors are usually willing to forgo current income in favor of possibly earning substantial future capital gains. The rate of return, or yield, is the total return on an investment expressed as a percentage of its price. It is usually stated on an annualized basis. For example, if Nina sells the H&M stock for $52 per share after one year, she will have a total return of $800 ($300 in dividends plus $500 in capital gains). Her yield would be 17.78 percent ($800 +$4500).

SHARE

.

• 
• 
• 
• 
•