1.3.2 Investment returns
The returns that are received from investing fall into two categories – income and capital growth. Income can come in the form of interest on savings accounts and bonds, or dividends on shares.
Capital growth can come in the form of the increase in the value of the assets – higher share prices, increases in indices for investments contractually linked to a market index (like a stock exchange index) and higher bond prices for those bonds that are marketable. For savings accounts, though, there is normally no potential for a growth, or risk of a decline, in capital value. The money placed into an account does not change in nominal value and the only returns received are the interest paid on the account.
Three particular factors need to be borne in mind when measuring and forecasting investment returns:
- All returns should be measured in real terms, not nominal, by accounting for the impact of price inflation on the value returned to the investor through income or capital growth.
- Assets whose prices can move can clearly move down in price in nominal terms as well as increasing in price. Care needs to be taken when investing in those assets with price sensitivity – particularly if the investment period is short. As you examine different types of investments in Weeks 2 and 3, you’ll see that there is a relationship between risk and return – this being that those assets that offer the greater returns, are associated with greater risks in terms of the volatility of the value of the investments and the prospect of default by the entity with whom the investment is placed. In Week 3 you’ll look closely at the types of financial risks investments may be exposed to and at how effective risk management is central to investment management.
- There is an inverse relationship between interest rates and the capital value of assets. A period of high interest rates may have the impact of depressing share prices due to the impact of high rates on economic activity and hence on the performance of companies and, by consequence, their share prices. For some assets, like fixed-rate bonds, there is a certain mathematical relationship between interest rates and asset prices: if interest rates rise, bond prices will fall (and vice versa). You’ll learn more about this in Week 2.
Investment returns – tax breaks and tax wrappers
A crucial element to factor into investment planning is the tax treatment of the returns. Some investments have what is referred to as a ‘tax wrapper’, where the returns are protected from tax of either the income they generate or any gains to capital gains. The most common example of these in the UK are Individual Savings Accounts (ISAs) where returns are tax free (with the exception of the taxation of dividends received on Stocks & Shares ISAs). Elsewhere, even where investment returns are subject to taxation, annual tax-free allowances can be used to protect at least part of the returns from tax deductions. You’ll look at the tax treatment of returns from personal investments in the UK in more detail in Week 2. At this stage, the key point to note is that for your preferred form of investment you should make sure that you take advantage of any tax exemptions on their return.