Money Matters: A Beginner’s Way of Understanding Returns

Getting returns is the main purpose of investing your money. It’s usually expressed as a percentage change in the value of your investments. The simplest way to illustrate returns is when you have P100 and you gain P10 from investing your P100, you have a 10% return on your investment. A quick and dirty way of computing the rate of return is by dividing the additional money you get, P10, by your initial investment, P100. This results in a rate of return of 10%.

When it comes to investing, there are many investment products to choose from, and if your strategy in choosing products is just focusing on the products with the highest returns, you might eventually lose all the money you invest. The reason why we have to make critical and specific investment decisions is that returns have a direct relationship with risk. That is to say: don’t ask for more returns if you’re not willing to take on more risk. To understand further what risk is about and how it can be applied in your decision making, check out our previous article Risk Profiling: Knowing Thyself in the Financial Perspective.

In this article, we’ll be taking a closer look at returns. We’ll be covering the basics of what fees are usually overlooked in investing and where you can find accurate data on the returns you can actually get.

There’s No Such Thing as Easy Money

A common misconception people have on returns is that returns are straightforward. If an investment product says that it historically had 10% returns in the past year most often than not, people would assume to receive the same amount this year. However, as informed decision-makers, we must be aware of the uncertainty of returns when it comes to investing your money.

A good example would be the Enron scandal in 2001. It’s one of the most famous bankruptcies in business history. Let’s look at the scenario from the perspective of an investor. The company’s operations revolved around energy generation and commodities. Enron was a really good company as it was awarded the “Most Innovative Company” by Forbes for multiple years. It had a good balance sheet and was one of the top companies in the world. Its stock price was rising and it had no signs of slowing down. It’s an obvious decision to ride the wave and invest in Enron. However, in a span of a year, Enron’s stock price plummeted. From 80 USD a share, it went down to just around 0.29 USD a share. Enron was caught inflating its revenues.

Though the reason for Enron’s decline in share price was due to their fraudulent reporting becoming public, the point here is, what you see currently at face value may not always be an accurate basis for potential returns in the future. Risk is always present even when you think it’s not there.

There are some scenarios that you can never predict. For example, you would never have expected that a pandemic would happen this year. As a result of this, mutual fund values, the stock market, and other investments have lower return rates. Having read all available information about your investments won’t save you from unforeseen events such as this, but that should not discourage you to invest as economies recover eventually.

Finding a Good Balance of Maximizing Returns and Minimizing Risk

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When it comes to investing, there’s no shame in not knowing much when you start your financial journey. Investing isn’t taught in schools, so just choosing to start makes you a cut above most people already. Like any other skill or hobby, you would need to put in time and effort into learning it.

For beginners, it would be better to start out with lower risk investments like mutual funds, bonds, or if you’re looking for insurance that’s tied up with a fund, you can invest in VULs from insurance companies. The idea behind going for lower-risk investments is that while the potential gains are less, the chances of experiencing a devastating loss is likewise decreased.

The main reason why mutual funds and bonds are less risky than direct stock investments is because of the nature of these investments, mutual funds work by allocating your money into different assets and in turn diversifies your risk. For example, if you invested in a single stock and its price drops 10%, the value of your entire portfolio drops by 10% as well. Investing in a more diversified mutual fund reduces your overall risk as opposed to putting all your money under one stock. One or a few stocks in the fund may be performing poorly, but the rest could be providing sufficient returns — may be enough to cover the losses from the underperforming stocks.

For bonds, you are loaning the company or even the government money. It is unlikely for large companies and especially the government not to be able to pay their debts. With that, there’s more assurance for you to receive your money with the returns that you deserve for loaning them money. You can learn more about these two types of investments in our other articles specific to these topics.

It is important to remember that information can mitigate risk but only up to a certain extent.

Start Early, Get More Returns

If you refer back to our first article on personal finance, one of the tips there is to start early to accumulate as much wealth as you can. The reason why starting out as early as you can is important is because of the concept of compounding. Essentially, the miracle of compounding is interest on interes, but best way to explain this conceptis through an illustration. Let’s compare a person who invests P50,000 this year to a person who’s going to invest P50,000 five years from now and see who has more money at the end of 10 years. Let’s assume the return rate of 5% per annum for this investment. This means your principal amount of P50,000 will earn 5% per year or you’re going to earn 5% of every peso you invest.

Looking at the computation, the difference between the two investments at the end of 10 years amounts to almost P20,000 pesos or almost 40% of your initial investment. The idea of compounding is that as you gain more interest or returns every year, the principal investment or the value of your investment grows as well as long as you keep your money in the investment. To simplify it, you earn more next year than you would earn this year as long as the interest or return rate is the same. When they said that time is money, they really weren’t kidding.

Another concept you should know is peso-cost averaging or the strategy of regularly investing in a stock or other securities at regular intervals.. The stock market is volatile, and only God knows what might happen in the future. Thus, regardless of what is happening in the market, an investor using this strategy will buy into the highs and the lows resulting in the price he pays averaging out. For example, if you decide to invest a total of Php 5000 divided into monthly Php 1000 purchases of stock over 5 months, you will consistently stick to this plan regardless of whether the market is up or down. Say the price of a stock in one month is Php 10, then you will be able to buy 100 shares. The following month, if prices fall to Php 5, you will still buy, but this time you will be able to buy 200 shares — allowing you to buy more shares and realize gains once prices rise again. Yes, your initial investment may have incurred a Php 500 loss, but this is less emotionally taxing than incurring a Php 2500 (10–5/100*5000) loss from using a lump sum investment strategy. Peso-cost averaging is a counter-strategy to timing the market and is a great option for those who lack the time and expertise to do so. This strategy however does not absolve an investor from losing money if a stock tanks. But if you keep doing this for the medium to long term, investing in a stable company with a positive outlook (ex. Blue-chip stock), eventually you will end up with a healthy profit, without having to deal with the same volatility. Having enough discipline to put aside money regularly to grow your investment portfolio would be the best way to have more of your money work for you which in turn increases your returns as well.

Return Rates and What do They Mean

When it comes to return rates, you will see products online with rates that have various names. Though there are different meanings to the different rates, the same rule-of-thumb applies that the higher the rates of return, the better since these rates are based on historical data. Let’s dive deeper and learn about the common rates we see on investments.

Year-to-Date (YTD)

This rate is straight forward. It’s the rate of return received from the start of the calendar year to the current date. For this rate, it takes into account the value of the investment on the first of January of the present year to the present date. For example, if the value of my money market fund at the start of the year was P10,000 and it’s now at P10,200, the year-to-date rate would be at 2%.

What this rate shows is the performance of the investment for the current year, and in terms of decision making, this rate is better to use for comparing investments as you limit the return rate to a specific time frame.

Coupon Rate

The interest rate for bonds is called a coupon rate. As said before, bonds are investment vehicles where companies loan money from you. The coupon rate is the interest rate you are receiving from them or the returns you get for investing your money through the bond. In this investment, it’s pretty simple. When you buy a bond for P100,000 and its coupon rate is 5% per annum, you get P5,000 each year as interest from the bond.

Yield-to-Maturity (YTM)

This is a return rate used for bonds. This YTM rate is the anticipated return rate assuming the bond is held until its maturity. When it comes to bonds, you can either hold it or sell it to another buyer when you need your cashback. This YTM rate applies when you choose to hold the bond until it matures.

This rate is a good metric to determine which bonds to invest in compared to other bonds. Computing for this rate is more complex and less intuitive than that of the coupon rate. The YTM rate varies and changes when the bond’s market value changes as well — as bond prices rise, yields fall, and vice versa. To learn more about computing for YTM, you can refer to this link.

Return on Investment (ROI)

Return on investment is determined by the current value of your investment compared to the initial value of your investment. This rate is usually historical in nature, which means it may be a means to predict what your future returns are but there is uncertainty of it being at the same rate, and is applied to various funds.

This is computed by dividing the additional value of your investment relative to your initial investment. For example, if you invested in a mutual fund using P10,000 and the fund’s value now is P12,000, your ROI is at 20%. ROI reflects the performance of a fund and is a good basis in determining what fund to invest in. However, do note that future performance is not always determined by historical performance meaning, there may be changes in the market that you cannot foresee which may affect the performance of your investments — thus affecting your returns.

Take Note of the Fees

When it comes to investing, there are certain fees you have to take note of. The fees serve as revenue for the financial intermediaries offering you the investment products. The fees vary from each financial institution to another, but these are a few of the common fees you may be encountering once you start investing.

Management / Handling Fees

For mutual funds such as index, equity, money market funds, etc in the Philippines, the range of management or handling fees is usually from 1%-3% of your investment’s total value. When you compute for the returns of your mutual funds, you will have to take this into account. However, in some cases, the computation of the management fee is already included in the fund value. Once you invest, you can clarify this with your fund manager or the financial intermediary you chose to handle your investment.

Front-end Fees

These are fees directly deducted when you start the investment. This fee is included whenever you add funds to your investment, but the larger the additional investment, this fee is usually lower or sometimes taken out completely. This is usually called the sales-load fee or the processing fee of your initial investment and your succeeding top-ups to the investment. For example, if you have a 1% front-end fee and you choose to invest P5,000, the actual amount that goes into your investment is P4,950. Additionally, when you already have P5,000 in your investment and want to add an additional P2,000 in your investment, only P1,980 actually goes into the investment assuming the same 1% rate applies.

Transaction Fees

There are some fees that come with every transaction. For example in stock markets, they have fees for both buy and sell transactions. This varies with the broker you’re coursing your trades through. Both buy and sell transaction fees are around 1.19% of your investment value, so take note of these when looking at your returns. Your return on investment would need to be more than your fees to actually earn from your investments.

Just to sum it all up, just remember that when it comes to returns, always be mindful of its relationship with risk and how having more information on your investment can mitigate some of that risk. Remember to keep in mind that transaction fees affect your returns, and be wary of what their advertised return rates actually mean. We hope this article helped you understand the different factors that you have to consider when you make your investment choices. Let’s not go in blindly with any investment decision we make!

- UP JFA Pisopedia