6: The Trade-Off Between Risk and Returnrealised or unrealised, but it has no effect on the investor’s wealth (at least if we ignore taxes). At the end
of the year, the investor has $60 in cash plus a bond worth $875.06. That is equivalent to owning $935.06
in cash, which would be the investor’s position if she sells the bond.^2 In any case, this example illustrates
that both the income and capital gain or loss components influence an investor’s wealth. The important
lesson to remember is that one must focus on the total return when assessing an investment’s performance.
6 -1b DOllAR RETURNS AND PERCENTAGE RETURNS
We can describe an investment’s total return either in dollar terms or in percentage terms. Consider again
the bond example in the previous three paragraphs. To calculate the dollar return on this investment, we
simply add the income component to the capital gain or loss:
Eq. 6.1 Total dollar return = Income + Capital gain or loss
Earlier, we defined an investment’s total return as the change in wealth that it generates for the
investor. In the present example, the investor begins with $1,000. A year later, she receives $60, and she
owns a bond worth $875.06. Therefore, end-of-year wealth equals $935.06. The change in wealth due to
this investment’s performance equals –$64.94 ($935.06 – $1,000), which we can verify by plugging the
appropriate values into Equation 6.1:
Total dollar return = $60 + (–$124.94) = –$64.94
Dollar returns tell us, in an absolute sense, how much wealth an investment generates over time.
Other things being equal, investors prefer assets that provide higher dollar returns. However, comparing
the dollar returns of two different investments can be treacherous, as the following example illustrates.
exampleTerrell purchases 100 shares of Micro-Orb shares for $25 per share. A year later, the shares pay a dividend of
$1 per share and sell for $30 per share. Terrell’s total dollar return is:
Total dollar return = (Number of shares) × (Dividend income + Capital gain)
Total dollar return = 100 × ($1 + $5) = $600
Meanwhile, Kumar purchases 50 shares of Garcia Transportation Ltd for $15 per share. Garcia shares pay
no dividends, but at the end of the year, the shares sell for $25 per share. Kumar’s total dollar return equals:
Total dollar return = 50 × ($10) = $500
Based on these figures, it appears that Terrell had a better year than Kumar. But before we reach that
conclusion, we ought to recognise that at the beginning of the year, Terrell’s investment was much larger than
Kumar’s.
The preceding example illustrates a problem we encounter when comparing dollar returns on
different investments. Terrell’s dollar return exceeds Kumar’s by $100, but that does not necessarily
mean that Terrell’s investment performed better. Terrell spent $2,500 to purchase 100 Micro-Orb shares,
2 Unrealised losses are sometimes called paper losses. This term simply means that the value of the paper that an investor holds (a bond or
share certificate) has gone down. Some investors believe that paper losses are irrelevant and that losses only matter when they are realised
because an investor sells. However, even a paper loss incurred by an investor will reduce her wealth.