In the concept of portfolio theory, investors get the benefit of holding portfolios of investment vehicles, not just a single asset or security. Typically, the greater the risk of portfolios the greater the return the portfolios generated.
In this article, we cover the definition of portfolio return, how to calculate the portfolio return with example and interpretation. Therefore, let’s dive in!
What is Portfolio Return?
Before jumping into the portfolio return, let’s understand what a portfolio is. A portfolio is defined as the collective of investment vehicles or assets or securities. This means that each individual asset or security that assemble to meet one or more investment goal form a portfolio of investment vehicle.
Thus, we can define the portfolio return as the total return of each asset or security in a portfolio. We sometimes call it a return on portfolio and these two words can be used interchangeably.
Basically, the ultimate goal of investors is to ensure that they can get efficient portfolios; the portfolios that can generate a higher income. The income here can be from both price appreciation and direct income in the form of dividends or interest or can be both. This is called holding period return.
When investors want a price appreciation, they will tend to buy the assets or securities and hold them for long-term price appreciation and then sell out to get a big capital gain. However, at the same time, they will still get income in the form of dividends or interest but this income is relatively small as compared to the long-term price appreciation. For this kind of investor, they will tend to look at the portfolios; especially with a high tech industry that does not focus on growth prospects.
Another group of investors wants a high income from holding the portfolios. This income comes from dividends or interest. For this kind of investor, they will tend to look at portfolios that have a high historical payout ratio or income yield.
How to Calculate Portfolio Return?
In order to calculate the portfolio return of the investment vehicles, we need to know the return of each asset. Then, we calculate by multiplying the return of each asset with its proportion of that asset value and add up together. By doing so, we get a weighted average return of the whole investment portfolios or securities.
Below is the formula that we use to calculate the portfolio return of investment:
Rp = WA × RA + WB × RB + WC × RC + ……… + WN × RN
Where:
WA is the proportion of the portfolio’s total value of asset A
RA is the return of asset A
WB is the proportion of the portfolio’s total value of asset B
RB is the return of asset B
WC is the proportion of the portfolio’s total value of asset C
RC is the return of asset C
WN is the proportion of the portfolio’s total value of asset N
RN is the return of asset N
Example
ABC Fund is a large portfolio management company. The portfolio consists of five assets. The table below summaries the proportion of investment value as well as the return of each asset:
| Portfolio A | Proportion (W) | Return (R) |
|---|---|---|
| Asset 1 | 10% | 14.5% |
| Asset 2 | 25% | 15% |
| Asset 3 | 25% | -5% |
| Asset 4 | 20% | 14.5% |
| Asset 5 | 20% | 13% |
| Total | 100% |
We can calculate the portfolio return of the portfolio by using the below formula:
Rp = WA × RA + WB × RB + WC × RC + ……… + WN × RN
From the table above, we can calculate the return as follow:
Rp = 10% × 14.5% + 25% × 15% + 25% × (-5%) + 20% × 14.5% + 20% × 13%
Therefore, Rp = 9.45%
Interpretation and Analysis
The overall return is at 9.45%. That’s means, overall, the company is able to generate a return of 9.45% even though one asset in the portfolio generates a loss of 5% on its investment.
In order to evaluate whether the levels of this return is good or bad, we need to compare it with other portfolios. Let’s assume that the other two portfolios, B and C generated an overall return of 13% and 5% respectively. So how is the return of portfolio A as compared to these two portfolios?
That means portfolio A can generate a favorable overall return as compare to portfolio C; however, it generates a lower return as compared to B.
Conclusion
Return on portfolios is a good measure to assess efficient investment portfolios. It enables investors to decide on which portfolio they should exploit in order to generate the maximum return.
