Analyzing Returns

When you make investments, you have the potential to make money in a variety of ways. Each type of investment has its own mix of associated risks that
you take when you part with your investment dollar and, likewise, offers a
different potential rate of return. In this section, I cover the returns you
can expect with each of the common investing avenues. But first, I walk
you through the different components of calculating the total return on an
investment.

The components of total return
To figure out exactly how much money you’ve made (or lost) on your investment, you need to calculate the total return. To come up with this figure, you
need to determine how much money you originally invested and then factor
in the other components, such as interest, dividends, and appreciation (or
depreciation).
If you’ve ever had money in a bank account that pays interest, you know that
the bank pays you a small amount of interest when you allow it to keep your
money. The bank then turns around and lends your money to some other
person or organization at a much higher rate of interest. The rate of interest
is also known as the yield. So if a bank tells you that its savings account pays
2 percent interest, the bank may also say that the account yields 2 percent.
Banks usually quote interest rates or yields on an annual basis. Interest that
you receive is one component of the return you receive on your investment.
If a bank pays monthly interest, the bank also likely quotes a compounded
effective annual yield. After the first month’s interest is credited to your
account, that interest starts earning interest as well. So the bank may say
that the account pays 2 percent, which compounds to an effective annual
yield of 2.04 percent.
When you lend your money directly to a company — which is what you do
when you invest in a bond that a corporation issues — you also receive interest. Bonds, as well as stocks (which are shares of ownership in a company),
fluctuate in value after they’re issued.