How do financial returns work?

You’ve probably already wondered how your investment returns are calculated. Why is the return on your investment statement different from the one for the mutual fund you own? How is a fixed return different from a variable return? What is the difference between simple and compound interest? Let’s untangle these important concepts.

Return measures the change in value of an investment over a given period. It is expressed as a percentage of the investment’s value at the beginning of the period. When the period exceeds one year, the return is generally expressed on an annualized basis, which represents an average return per year.

Some investments, such as most Guaranteed Investment Certificates (GICs), offer fixed returns. This way, you know in advance what return you’ll get on your capital. However, most investment vehicles have variable returns that fluctuate according to a variety of factors, including interest rates and stock market movements. For example, if you invest in an exchange-traded fund (ETF) that replicates the performance of the S&P 500 index, your return will vary from year to year and could be negative.

There are two main methods for calculating returns: the time-weighted return (TWR) and the dollar-weighted return (DWR). Both methods are valid, but they offer different perspectives on the evolution of your investments.

This method aims to calculate the return on your investments over a given period by neutralizing the impact of cash movements. This means that the TWR is not influenced by your decisions to make additional contributions or withdrawals from your investment portfolio. By separating your decisions from those of the portfolio manager, the TWR lets you compare the performance of different investments. This method allows you to evaluate mutual funds with similar strategies, for example.

The amount and timing of your contributions and withdrawals can have a significant impact on your rate of return. In some cases, the TWR method may show a return quite different from the one actually obtained. The DWR gives you a more accurate picture of your personal performance by taking into account cash movements in your investment portfolio. 

Example of the impact of contributions on the rate of return

In the above example, the mutual fund’s annualized TWR is 3.58%, while the investor obtained an annualized DWR of 5.21%¹. The contributions made during years of positive fund performance boosted the annual gains. Of course, the opposite would have occurred if a large contribution had been made in a negative-return year.

Another concept that influences the rate of return is compound interest. Unlike simple interest, which is calculated on the initial amount contributed, compound interest is capitalized, i.e., added to the initial capital to calculate future interest. In other words, it allows you to earn interest on interest, creating a “snowball” effect which maximizes your long-term savings.

The above example clearly illustrates the power of compound returns. The capitalization of interest would generate an additional return of $1,288.95 over a 10-year period!

You can observe the effect of compound returns with the return calculator on the Autorité des marchés financiers (AMF) website.

If you’d like to save for the education of a special child, the registered education savings plan is a particularly advantageous vehicle, since generous government grants are added to your contributions². Over time, your savings and government investments grow tax-free.

Return is an important aspect of an RESP, since interest accumulates not only on your contributions, but also on the government grants. The grants increase the amount on which compound returns are calculated, creating a highly attractive exponential effect! 

In short, there are two main methods for calculating returns: one that allows you to compare the performance of different investments, and one that measures your personal return, taking into account the timing and amount of your contributions and withdrawals.

But beyond calculation, it’s important to know the different types of return. Fixed or variable, simple or compound, they will influence the variability and rate of return of your investments over the long term.

Compound returns are particularly attractive, as their exponential effect can let you reach your financial goals more quickly. This is especially true for RESPs, where interest accumulates not only on your contributions, but also on government grants.