Three different and essential ways to measure an asset rate of return
When it comes to investing, knowing how to measure and what to measure is needed in order to know how well you do and whether the specific actions taken leads to desired results and if no, why not. While it is a fact that past performance does not equal future results, that is a pretty common saying in finance literature anyway, ordinary investors can nevertheless gain insights, subsequently derive expectations that can be reasonably achieved, so as to build sound and effective portfolios from wise analysis and study of various assets’ historical rates of return data that is available publicly or for a small price.
Bear in mind that there are three ways of organizing rates of return data, from there; one can observe several things useful to investors when doing asset allocation. By looking at the rates of return from these three perspectives, one can have a better gauge of: 1) the best and worst returns within a certain time period for each specific asset class; 2) An asset return by individual years 3) how asset classes do in various broad economic conditions.
1. An asset annual rate of return by year’s group
This basically means compound annual rates of return over a time period of 5, 10, 20 or 30 years. In other words, the value of the asset at year 0 is the present value, at year 10 is the future value and the rate of returns is the interest rate in time value of money calculations for compound annual rates of return.
Take note when analyzing data of returns by groups of years, the returns presented in this way is the nominal and total return. By nominal, it means that the returns do not take into consideration the erosion of purchasing power of the dollar by inflation. The real return can be easily calculated by minus away the nominal return with the inflation rate. Total returns assume that dividends from stocks and interest payments from bonds are reinvested instead of not counting them. In addition, which currency the return is calculated on will affect significantly the annual rate of return also, For instance, if the rates of returns are expressed in U.S. dollars, and over the group of years measured, if your local currency has appreciated in value against the U.S. dollars, the actual rate of return will be higher and vice versa.
The final caveat of measuring an asset annual rate of return by group of years is that it is at best gives you an idea of the order of magnitude return that one might reasonable expect to earn by investing in this asset class. They are of course no guarantee of future results.
2. An asset annual rate of return by each year
This organize return data by how they changes from year to year. In other words, the percentage changes in assets’ prices from start of and to end of calendar year. Some caveats when looking at data organized in this way, dividends are not considered in year to year changes in prices and not deducting away taxes also. Otherwise, the things to take note are the same as above for this case also.
3. An asset annual rate of return by broad economic conditions
Different asset classes tend to perform rather similar when facing the same economic conditions when compared to the past. As a result, there is a good chance that they will behave in the same way when the same economic conditions repeat in the future. For simplicity and practical usage, we will divided the economic environment into four distinct conditions: 1) rapid inflation; 2) deflation; 3) moderate inflation; 4) stability in prices (neither inflation or deflation)
There is a need to strategically emphasize or de-emphasize one asset class over another during each of these four economic environments. In general, in the eras of rapid inflation, one can increase holdings in precious metals such as gold and silver, and less in bonds. The following is general information regarding heavy weightings in specific asset classes under each of the four economic conditions. When there is rapid inflation, which happens for a particular city state just after the General Election, one can allocate more towards real estate, precious metals like gold and silver, medium weightings on stocks, while lesser on cash equivalents and bonds. When there is deflation, lesser weight should be given to stocks, heavy percentage in bonds, cash and cash equivalents and medium weightings to real estate. For the case of neither inflation nor deflation, that is stability in prices, equities will better be in highest percentage, medium proportion in bonds and real estate, low weightings in cash equivalents and almost negligible holdings in gold and silver.
The general descriptions of asset class holdings in various economic conditions are only in general and should not be treated as hard and fast rules or gospel. In fact, they do not consider the fact that there are other ways to hedge against price increase or decrease, does not consider the individual investor’s risk profile, information and transactions costs when switching between different asset classes, liquidity attributes and investment vehicles for holding assets.
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