The Many Faces of Return: Understanding Investment Performance

I'm Andy Temte and welcome to the Saturday Morning Muse! Start your weekend with musings that are designed to improve financial literacy around the world. Today is August 23, 2025.

Last week, we explored inflation and how it erodes purchasing power over time. We also connected this concept back to our August 2nd episode where we introduced the interest rate equation: expected inflation + real risk-free return + risk premium = interest rate. Today, we're diving deeper into one of those components—the concept of "return"—and discovering why understanding different types of returns is crucial for making smart financial decisions.

In our August 2nd discussion, we defined real return as compensation beyond just maintaining purchasing power—essentially, what you earn after accounting for inflation. But the world of investment returns is far more nuanced than this single definition suggests.

Think of returns like temperature measurements. Just as we have Fahrenheit, Celsius, and Kelvin to measure heat under different circumstances, we have various ways to measure investment performance depending on what question we're trying to answer. Each return calculation serves a specific purpose and tells us something different about an investment's performance.

Different Types of Return Computations

Let's start with nominal return—the most straightforward calculation. This is simply what your investment gained or lost, without adjusting for inflation. If you bought a stock for $100 and sold it for $110, your nominal return is 10%.

** Multiply the calculation by 100 to convert decimals into a percentage return.

But as we learned from our inflation discussion, nominal returns can be misleading. If inflation ran at 4% during your investment period, your real return—your purchasing power gain—was only about 6%. Remember from our August 2nd episode that real return represents the combination of the real risk-free rate plus any risk premium you earned. Over longer time periods, even modest inflation rates compound and significantly reduce the purchasing power of what appears to be a healthy nominal return.

Holding period return measures your total gain or loss over the period you owned (or held) an investment. If you bought that same stock for $100, received $5 in dividends, and sold for $110, your holding period return would be 15% [($110 + $5 - $100) ÷ $100]. This calculation captures everything you earned from the investment during the holding period.

** Multiply the calculation by 100 to convert decimals into a percentage return.

Total return is similar to holding period return but is typically expressed as an annual figure that includes all sources of return—capital gains (the profit from selling an investment for more than you paid), dividends (cash payments companies make to shareholders), and interest (payments from bonds or savings accounts). In most cases, total return and holding period return are essentially interchangeable.

For comparing investments over different time periods, we use Compound Annual Growth Rate (CAGR). This return measure smooths out year-to-year volatility to show what constant annual return would have produced the same end result. If an investment doubled over seven years, the CAGR would be approximately 10.41% [[($2 - $1)/$1]^1/7 - 1], even if the actual yearly returns varied dramatically. We'll explore the power of compounding and compound annual returns in detail in upcoming episodes.

Historical Foundations

The mathematical foundations of return calculations trace back to ancient Babylonian and Egyptian civilizations, where merchants needed to calculate profits from trading expeditions. However, our modern understanding of investment returns developed alongside the evolution of financial markets.

Italian mathematician Leonardo Fibonacci, famous for the Fibonacci number sequence, also contributed to early compound interest calculations in his 1202 work "Liber Abaci." These concepts laid the groundwork for understanding how money grows over time.

The Dutch mathematician Johan de Witt, who served as the Grand Pensionary of Holland in the 17th century, made crucial contributions to what we now call present value calculations. His work on life annuities and government bonds helped establish principles for valuing future cash flows—essential concepts for modern return calculations.

Benjamin Franklin popularized compound growth concepts in American culture with his famous observation that "money makes money, and the money that money makes, makes money." His mathematical demonstrations of compound interest helped colonial Americans understand how small, consistent investments could grow substantially over time.

Why Different Return Calculations Matter

When evaluating the performance of your portfolio, you need to look at real returns, not just nominal returns. An 8% annual return looks less impressive when inflation has been running at 3%, leaving you with 5% in purchasing power gains.

Marketing materials from financial firms often highlight their best-looking return numbers. An actively managed fund might advertise impressive short-term holding period returns while glossing over poor risk-adjusted performance or high fees that erode long-term real returns.

When comparing investment options, CAGR helps you see through the noise of year-to-year volatility. Making apples-to-apples comparisons is critical! A consistent 7% annual return often beats a flashy investment that gains 20% one year and loses 10% the next, even if the average looks similar.

Tax implications also matter. Your after-tax return is what really counts for building wealth. An investment generating 10% in a taxable account might net you less than an investment yielding 8% in a tax-advantaged retirement account.

Building Your Foundation

The key insight for now is this: not all returns are created equal, and the number that matters most depends on your specific situation and goals. Understanding these distinctions empowers you to ask better questions, make more informed decisions, and avoid being misled by flashy marketing materials that emphasize the most favorable return calculation while ignoring others.

Until next week...

Grace. Dignity. Compassion.