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Wealth & Pension Services GroupWilliam Kring, CFP, AIF - Chief Investment Officer09/22/15
When do prices become misleading?
Investment returns for income focused investments such has bond funds, are frequently misunderstood. This is because investors typically rely on pricing and charts from web sites which do not reflect total return. The goal of this piece is to provide clarification on why investors should focus on total return rather than price, and demonstrate the power of income reinvesting and compound interest.
The chart above illustrates the 15-year returns of a hypothetical investment of $100,000 in a high yield mutual fund. The blue line shows the return of only the price of the underlying fund during this period, while the green line displays the total return which includes the reinvestment of income distributions. One can clearly see that the “price only” return is not reflective of the investment’s true return potential. This is due to the fact that the price of a mutual fund drops by the amount of its capital gains distributions. Secondly, the blue price-only line does not reflect re-invested dividends and capital gains, and the associated power of compound interest, which is revealed by the “total return” line.
Compound interest is defined as: “Interest computed on the sum of an original principal and accrued interest.” It is achieved by choosing to reinvest income distributions instead of taking them. This reinvestment can lead to superior returns as the additional reinvested income subsequently produces more future income and compounds over time.
Focusing solely on an income oriented investment’s price can be very misleading. It can cause an investor to prematurely sell or even avoid an investment that may otherwise be a good idea. When evaluating performance, investors should seek information on a security’s income and total return, rather than its price-based chart.
As always, please feel free to contact us with any questions you may have.
William Kring, CFP®, AIF®Chief Investment Officer
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