Introduction to Investments

Prof. S G Badrinath
Rates of Return-Review and More

In this session, I intend to go through some basic calculations pertaining to how you measure rates of
return. Some of this is really, really basic. Perhaps, even at the high school or lower level, but part of
its intention, that's why it's called review and more, is to sort of get us all on the same page in terms
of how we view performance of different types of investments. So, with that said, let's take a look at
rates of return and more.

The most obvious thing, the basic thing is to think in terms of an investment of a 100 dollars that
compounds over a period of one year to a value over 120, we all know how to calculate the percentage
rate of return in this world that we are now learning to live in. It's sometimes called an HPR or a
Holding Period Return, and it's basically just a percentage change from a 100 to a 120 in whatever
units you want to think about it, rupees, dollars, other currencies. The obvious connection to a basic
finance notions that most of you should be familiar with is of time-value of money. Think of the 100
as the present value. The 120 as the future value. 1 as the time frame over which this investment was
made. Obviously 20% is the rate of return that accrued over this period of time. Let's skip to the next
slide where in addition to just having a price appreciating from a 100 to a 120, there’s also a cash flow
called a dividend of 5 dollars that is paid, or 5 rupees that is paid at the end of this period.

How does that affect the rate of return? What that does is all you have to do is to add it back into the
holding period rate of return calculation. The 5 goes back in here, and now instead of 20%, which was
the previous part, there is an additional 5% incremental growth. So, you have a 25% rate of return on
this thing. The common way in which people think about this is to think of the price appreciation part.
The 120 to a 100 as a capital gains return or a capital gains yield and the 5% as a dividend yield. If this
was not a stock, but it was a bond, of course it would be a coupon-yield instead of a dividend-yield.
But that's how you, kind of, decompose your 25% rate of return into its two component parts.

What if this period was not a year? What if it was less? There is a process of annualization. That is also
something many of you have learnt about, I'm moving this along as quickly as I can, because I'm
guessing most of you know how to do this. In the annualized rate of return idea, let's say you've agreed
to borrow $9,900 and repay 10,000 in a month. Obviously, you've paid a 100 dollar in interest at that
period. How do you convert that one month's interest into an annual rate of return, and why do you
do that? If you convert it as a percentage, the way we just saw how to do it, it's actually 1.01% holding
period for a holding period of one month. To convert it to an annual rate, do you just multiply it by 12,
or do you compound it over 12 months? The APR, which is what most credit card companies like to
quote for you when you borrow money, and remember how credit card processes work, you typically
repay at the end of each month some portion of your balance. APR requires you to just multiply by
12. If you compound instead, it means you’re paying interest on interest. Then the EAR or the Equal
Annual Rate of Return is a little higher. The APR is what credit card companies like to tell you just
because it is a smaller number. Your effective rate of return, if you don’t pay out your full balance on
the credit card at the end of each month, is actually what the

© All Rights Reserved. This document has been authored by Prof. S G Badrinath and is permitted for use only within the course
Investments delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations,
pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical,
photocopying, recording or otherwise – without the prior permission of the author.
 Introduction to Investments
Prof. S G Badrinath
Rates of Return-Review and More

EAR says it will be. Notice there again how the numbers show you what happens. The HPR was 1.01%
for that month, multiplying by 12 gave you the APR of 12.12%. The effective annual rate where you’re
compounding the 1.01% over 12 months and that's kind of a compounding formula that you all know
already. That gives you a return of 12.82%. In the credit card world, that is interest charge, it is your
cost. Obviously, credit card companies would rather show you a lower number as a cost of the APR
rather than the EAR. Whatever it is, the EAR is assuming that you are compounding interest on
interest. This is a concept that you guys are pretty much familiar with, I would think.

How do you go to multiple periods of return, would be the next question that comes along, right? So,
go back to my initial example. You started with a 100 dollar investment at the beginning of time 0.
Two years later, it compounded to a 121 dollars or a 121 rupees. The compounding formula basically
says that you have to compound at some rate of return 'X' over two periods. X works out to be 10%
per year. That's your annual rate of return, or a holding period rate of return for a one year period. It
could come in different pieces.

The money does not, you know, I didn't tell you in the first slide where what happened in the
intervening period in the middle here, but supposing it was appreciated by 8% to a 108, the first period
and then to a 121. You have 8% returns in the first period, here and 12.04% returns in the second
period, compounds to 21 but the 21 is decomposed into 8 for the first and 12 for the second. That's
how, kind of, multi-period stuff works. So, do you take averages then to get back from a multi-period
setting of 21% to a single period setting of one year? The arithmetic average is 10. The geometric
average, which is just another way of averaging things is to take the two individual return pieces, take
a square root because it's averaging over time now. Take out the 1, because you start with the 1 dollar
in the beginning. That's a return of 10% as well. The usual practice in this business is, when you're
trying to find averages across time, you use a geometric average. If you're doing averages at the same
point in time over different groups of stocks, then it's okay to use the arithmetic average, which is
correct. Take a simple example and you'll see why the geometric average makes more sense.

Same kind of situation. You have a 100 dollar investment at the beginning. It actually lost half its value
at the end of a year, and then it doubled. The first year, your return was a negative 50%. The second
year, your return was a 100%. You take an average. The geometric average of the 100 and the 150
gives you, the arithmetic average gives you 25%. But, really, you didn't make any money over that
period. The 100 stayed the same. The geometric average is the correct one, and you can think of that
as a proof that the geometric average is the best way to average returns over time.

© All Rights Reserved. This document has been authored by Prof. S G Badrinath and is permitted for use only within the course
Investments delivered in the online course format by IIM Bangalore. No part of this document, including any logo, data, illustrations,
pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means – electronic, mechanical,
photocopying, recording or otherwise – without the prior permission of the author.