Investors can use many tools and resources to analyze their portfolios and the economy. The topics below are closely related:
Total return measures an investment’s overall gain or loss as a percentage of its original cost. In other words, it’s the investment’s overall rate of return.
A security can generate a return (or a loss) in three main ways:
Preferred stocks and some common stocks pay cash dividends as income. Debt securities pay interest as income.
Any security can also have a capital gain or loss:
Total return includes all of these gains and losses and compares them to the original cost. Here’s the formula:
Although calculations are generally few and far between on the Series 6, total return is a common test topic. The following video shows how to approach a total return question:
Now, try one on your own:
An investor purchases 100 shares of stock at $50 per share. The investor receives two quarterly dividends of $1 per share after holding the security for six months, then sells the security for $55 per share. What is the total return?
Can you figure it out?
Answer = 14%
Start with the total return formula:
You can calculate using total dollars or on a per-share basis. Either approach works. We’ll use a per-share approach to keep the numbers simple.
Now plug into the formula:
After-tax return is total return after accounting for taxes.
This can get tricky because different types of returns may be taxed at different rates. As covered in the tax considerations chapter, dividends and capital gains don’t always receive the same tax treatment.
Let’s work through an example:
An investor in the 24% tax bracket purchases 100 shares of ABC Equity Fund at $80 per share. Over the course of a year, they receive $2 quarterly dividends (per share). The investor redeems the fund at $90 per share exactly one year after purchase. What is the after-tax return?
First, identify the two sources of return:
For this investor:
*You can assume all dividend income paid from equity securities and funds is considered qualified and subject to 15% or 20% taxation, unless otherwise specified. If a test question identifies a dividend as non-qualified, it is taxable at the investor’s marginal income tax bracket (up to 37%).
Even though the investor purchased 100 shares, we can calculate on a per-share basis:
Applicable tax rates:
To convert each return to an after-tax amount, multiply by (100% − tax rate):
Now calculate after-tax return using the same structure as total return:
Here’s a video that breaks down after-tax return in more detail:
After you calculate the return on a portfolio or security, you’ll often compare it to a relevant benchmark index.
For example, large-company stocks are commonly compared to the S&P 500 index. If a stock is up 15% for the year while the S&P 500 is up 10%, the stock is outperforming the benchmark by 5%.
An index tracks the market prices of a pre-determined group of investments. For example, the S&P 500 tracks the stock prices of 500 of the largest US-based publicly traded companies, including Apple, JP Morgan Chase, and Amazon.
In general, an index reflects the average change in market prices of a basket of securities. Many indexes also apply weights, meaning some securities have a larger impact on the index than others. For example, changes in Amazon’s market price affect the S&P 500 more than changes in Alaska Airlines stock, because Amazon’s market capitalization is roughly 200 times larger. The larger the company, the more influence it typically has in a cap-weighted index.
Indexes typically use one of two weighting methods:
These are the relevant indexes to know for the exam:
The capital asset pricing model (CAPM) estimates a security’s expected return using only factors related to systematic risk. CAPM uses this formula:
Each input ties back to market-related (systematic) risk:
Example:
An investor is analyzing a large cap stock fund prior to making a potential purchase. The expected return of the S&P 500 is 12%, while the security reflects a beta of 1.5 and a standard deviation of 22. Additionally, the 3-month T-bill rate is 2%. Assuming the investor is utilizing the capital asset pricing model, what is the expected return of the large cap stock fund?
Can you figure it out?
Answer = 17%
Identify the inputs:
Now plug them into the formula:
The standard deviation is not necessary to perform this calculation.
Notice what CAPM does not include: Non-systematic risks such as business risk, financial risk, and liquidity risk. The model is designed to estimate expected return based on market dynamics and systematic risk only.
If this formula looks familiar, it’s because it uses the same components as the alpha calculation. The difference is the goal:
In 1952, economist Harry Markowitz published an essay on investing often viewed as the foundation of modern portfolio theory (MPT). The essay, titled Portfolio Selection, laid out principles for building an efficient portfolio - one that targets the highest expected return for a given level of risk (or the lowest risk for a given expected return).
To develop these ideas, Markowitz made several assumptions about investors, including:
These assumptions highlight a basic tradeoff: investors want higher returns, but higher returns generally require taking more risk. MPT’s key tool for managing this tradeoff is diversification.
A single security can be volatile (risky), but combining multiple securities can improve the portfolio’s overall risk/return profile. For example, losses in luxury cruise line stock during an economic downturn might be offset by gains in a defensive investment like pharmaceutical company stock.
With proper diversification, the risk/return profile of any one security becomes less important than the risk/return profile of the portfolio as a whole. That’s why a conservative, risk-averse investor might still allocate a small portion of assets to a higher-risk security and remain within a suitable overall portfolio.
To evaluate diversification benefits, investors often look at the correlation coefficient, which describes how two securities or portfolios have historically moved relative to each other. Correlation ranges from -1 to +1:
A key test point connects correlation to diversification: to diversify further, investors generally look for securities with negative correlation to the existing portfolio. Adding negatively correlated holdings can help reduce overall losses when the rest of the portfolio declines.
Diversification across securities is only part of the picture. Proper asset allocation also matters. Strategic asset allocation builds on MPT by emphasizing a suitable long-term allocation, avoiding market timing, and periodically rebalancing. Used correctly, it helps keep the portfolio’s risk/return profile aligned with the investor’s objectives.
Sign up for free to take 7 quiz questions on this topic