Returns in a financial context refer to the change in the value of an asset, investment, or project over a specified period. They measure an investment's profitability, which can be either positive or negative, representing profit or loss. Understanding returns is fundamental for investors as it helps them evaluate their investments' performance and make informed decisions about where to allocate their capital to maximize gains.
The calculation of returns involves comparing an investment's initial value with its current value. For example, suppose an investor purchases stocks at a specific price, and the value of these stocks increases over time. In that case, the return is determined by the difference between the purchase price and current price. This change in value over a period represents the return on investment.
Returns can be categorized into nominal returns and real returns. Nominal returns are the profits received from an investment before accounting for external factors such as taxes and inflation. They provide a straightforward gain calculation by subtracting the initial investment value from the current value. They do not give a complete picture of an investor's actual gain because they do not consider the impact of taxes and inflation.
This is where real returns come into play. Real returns adjust nominal returns by accounting for these factors, offering a more accurate representation of the investor's net gain. For example, if an investor faces a ten percent tax on the gain, the real return would be the nominal return minus the tax amount. Additionally, inflation, which reduces the purchasing power of money, must be considered to determine the true value of the returns.
