Understanding Total Return

It’s been a rough year for the market thus far, when looking at the return of your investment it is important to not just look at the price of the stock, bond, or fund, but rather its total return.  This can be measured using the Internal Rate of Return (IRR) and Excel can show this using the function XIRR or IRR.

The IRR is also known as money weighted return. This means that timing of additions to the investment matter.  This could be in the form of forced savings, or by dividend reinvestment.  For example, here are two similar situations, with different IRRs.  Starting with a $10,000 investment in a stock valued at $100 per share that pays $3 in dividends per year.

• Stock A pays $3 in December each year.
• Stock B pays $0.75 at the start of each quarter, for a total of $3 per year.

If dividends from both stocks were not reinvested during the year and the total account balance was $9900 at the end of the year, the IRR would be around 2%, but if they were reinvested, the IRR would be around -1%.

However, it is quite likely that the price of the underlying stock was different on the following dates:

• Jan 1st ($75 dividend from stock A, zero from stock B)
• April 1st ($75 dividend from stock A, zero from stock B)
• July 1st ($75 dividend from stock A, zero from stock B)
• October 1st ($75 dividend from stock A, zero from stock B)
• December 1st (zero dividend from stock A, $300 from stock B)

As such, the ‘when’ of when you receive the money impacts the IRR.  If we could control the timing of the market, it might be ideal to have a situation for Stock A as follows:

• Jan 1st, stock drops from $100 to $10 per share, dividends purchase 7.5 more shares.
• Jan 2nd stock returns to $100 per share. Total shares owned 107.5
• April 1st stock drops from $100 to $10 per share, dividends purchase 8.06 more shares.
• April 2nd stock returns to $100 per share. Total shares owned 115.56
• July 1st stock drops from $100 to $10 per share, dividends purchase 8.67 more shares
• July 2nd stock returns to $100 per share. Total shares owned 124.23
• October 1st stock drops from $100 to $10 per share, dividends purchase 9.32 more shares
• October 2nd stock returns to $99 per share, total shares owned 133.55

If at the end of the year in this (highly contrived) scenario the underlying stock price drops from $100 to $99 the account hasn’t dropped in value, since through excellent timing (buying stocks with dividend reinvestments at times of perfect pricing) the account owner now has 133.55 pieces of the stock, at $99 for an account value of $13,221.  The total return for the year would not be a loss of 1% (the change in stock price) but rather, a return of 32.14%.

If stock B moved in the same price pattern as stock A, the IRR would be different, because the holder of stock B would only purchase their new shares in December, at a price of $99 per share, and end up owning 103 shares at $99 per share.

The impact on cost basis

It is important to remember that due to the dividend purchasing more of the stock above, there is an impact to cost basis.  Each dividend payment, starting with $75 in January could have been used elsewhere.  Dividend taxation does not care if you reinvest or not, you are taxed as income, and as such, the amount used to repurchase more of the original stock impacts the cost basis, for stock A it would be as follows:

• Original Purchase Price $10,000
• January dividend $75
• April dividend $80.63
• July dividend $86.67
• October dividend $93.17
• Total dividends paid $335.47
  • Total Basis in stock: $10,335.47

If we were to sell the stock at a price of $99 per share our taxable gain would $13,221 minus $10335.47 for $2885.53.  The $335.47 in dividends would be taxed for the year received (regardless of a sale of the stock) and either at ordinary income or capital rates depending on how it was received. As such, your total return would still be 32.14% for the investment, but the manner in which it was taxed changes.

Same stock, different results

Another person could have bought exactly the same stock as above, and instead of reinvesting the dividends, used them for another purpose.  This creates an interesting micro/macro view. For example, if one was to take the $300 in dividends and invest those into Stock C, which appreciated from $300 to $400 over the year, the following rates of return could be witnessed:

• Stock A Basis $10000, end of year value $9900 IRR -1%
• Stock C Basis $300 (4x$75), end of year value $400 IRR 56%
• Total return $10,300 with income of $300, cap gain of $100 and cap loss of $100.

What can we do with this information?

Once we understand total return it puts market return into a different perspective, highlighting several important financial concepts:

Cap Gain and Cap Loss Harvesting

In the stock C example, we have the opportunity to determine when to sell to realize gains and losses, this can create opportunities to pay no taxes on the gain, while also creating a deduction on the loss. More on this here.

Tax Lot Selecting

With the example of Stock A being reinvested, and changing the total basis, we also open the door to tax lot selecting. This is where each purchase of the stock has a different basis rather than looking at total basis.  This allows us to cherry pick for capital gain harvesting, and can be used for strategic donation of appreciated assets. This is the same idea as Cap Gain and Loss harvesting above, though done within a single stock or fund that has multiple transactional basis.

Income source correlation

The degree of correlation between income sources impacts the risk tolerance that can be taken. We can consider the dividend to be an income source, but one highly correlated with the asset that produces it.  If we were to take RDS.A for example, and wished to buy more of it each quarter, we could rely upon the dividend of RDS.A to create an internal DRIP (dividend reinvestment program) system, or we could use an external source, such as bonds, salary, investment property etc.  This would allow strategic acquisition of the asset, which is the underlying principle of portfolio rebalancing.

Dollar cost averaging vs lump sum investing

We can go on to explore the value of dollar cost averaging (found within DRIP programs) vs lump sum investing.  While the dollar cost advocate might appreciate receiving 4 opportunities (each quarter) to DRIP, the lump sum investor would prefer to have the entire $300 upfront.  Studies have shown that we simply cannot get such ideal scenarios as I invented above, where the stock price dips to $10 exactly when we are buying it. As such, the notion of getting your money first, and investing it sooner can be a more successful approach. See more here.

Asset Location

Knowing that dividends are taxed during the year of receipt, regardless of the taxable sale of an asset, we can start to explore the location of dividend paying stocks. If income is high, it would be best to shelter the stocks within tax advantaged accounts, whereas if income is low, it might be fine to take the income tax due to deductions and low rates of ordinary income.

Value vs Growth Stocks

Broadly speaking a Value stock will offer a better dividend than a Growth stock, the latter fueling growth with excess reserves, rather than passing the money off to the investor.  This creates different tax strategies based on total return for the two asset types.

Conclusion

When you consider total return with the factors above, it really highlights how two people can be in the same market, or even the same stock within that market, and fair differently.  When you consider tax strategies, diversification and asset location, two people could hold the same stock for the same amount, yet fair very differently over time, as they are positioned differently from a macro view.

Total return should be the only return that matters, and getting your investment portfolios aligned correctly should ensure that they perform optimally over time.