Sometimes the most obvious concepts are the ones we tend to forget. In the case of investment strategy, the concept of total return is such a simple one that many investors neglect to account for it when building their portfolios. But don’t underestimate its significance.

Total return is the sum of two components—investment income (dividends or interest payments) plus capital appreciation (the growth of the investment’s market value). When combined, these elements give you the “big picture” of what your investment is doing for you.

The idea of total return applies to any investment that can fluctuate in market value. When you invest in growth mutual funds, stocks, or municipal bonds—to name a few—you need to consider total return, since these investments have a potential for gain and can appreciate over time. An investment such as a CD, on the other hand, offers fixed income with no chance for capital appreciation.

Total Return and Mutual Funds
When you invest in a growth mutual fund, for example, your return is made up of dividend payments plus any appreciation in the value of the shares you initially purchased. If you’ve invested for the long term, your dividends may be reinvested in the fund. As a result, you’ll see an increase in the number of shares you hold, increasing your potential total return.

In fact, there are mutual-fund portfolios that focus specifically on investments offering the potential for a high total return. Mainly, these funds invest in U.S. government securities such as Treasury bonds, GNMAs, and issues of other government-related agencies.

Total Return and Stocks
The stock market is one area where total return is a key indicator of your investment’s success. And over the long term, total return on stocks has consistently outpaced total return on other types of securities.

To see how total return can act as a measure of the market’s performance, consider that in the ten years from June 30, 1987 through June 30, 1997, the Dow Jones Industrial Average of 30 blue-chip stocks rose 217.25%, from 2418.53 to 7672.79—for an annualized return of 12.24%. On a total-return basis, however, the Dow rose 327.51% in the same period—for an annualized return of 15.64%! This illustrates the importance of total return in developing an equity portfolio, and underscores the importance of compounding.

Keep in mind that not all of the stocks in the Dow were or are exceptional performers; when investing in the stock market, selectivity is essential.

Total Return and Municipal Bonds
Total return can also be used to select bonds. Municipal bonds, for example, offer both fixed income in the form of tax-exempt interest payments, and the potential for capital appreciation, since when interest rates drop, bond prices increase. However, while the interest is tax-exempt, appreciation in the bond’s price, like any capital gain, is taxable.

Many investors consider only the tax-exempt interest when they think of municipal bonds. Yet the price appreciation on a muni can exceed its interest rate—making the total return more than double the interest rate. For example, in July 1985, an issue of hospital bonds went to market with a coupon rate of 9.75%. The issue was rated AAA. By February 1987, interest rates had fallen enough to raise the bond’s value to $1,185—$185 above par. Thus over 19 months, the bond paid $154 in interest—and rose $185 in market value—for a total return of $339, or an annualized rate of more than 20%.

While it would seem that the idea of total return is all too obvious, it is often neglected as the best way to judge an investment. Often investors are bombarded with “compounded rates,” “year-to-date rates,” “effective yields,” and so on. The prudent investor asks, “If I invest $1,000 in this today, sell it at $1,100 three years from now, and get 8.5% interest along the way, how much ends up in my pocket?"
Although other measures of return do have a bearing on one’s judgment of an investment, for most of us total return is the most telling. And that's the big picture.

Emily S Hazlett is Vice-President:Investments at ENB Insurance Agency, Inc. a wholly owned subsidiary of Evans National Bank.

Our firm does not provide legal or tax advice. Be sure to consult with your own tax and legal advisors before taking any action that would have tax consequences.