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Both organizations and individual investors trade a wide variety of financial securities with the intention of gaining returns upon these investments. Securities include exchanges involving:
Most commonly, reporting of investments will fall under the reporting of capital gains. Both organizations and individuals must report any and all capital gains within a given time period. These capital gains are profits derived from the sale of investments, which is to say that existing investments where capital is still tied in the underlying asset is not taxable (though it must be reported on the balance sheet for organizations as assets).
When profits from short-term investments are derived in a taxation period for an organization, this profit is reported on the income statement and taxed accordingly. Capital gains taxes can differ based on the duration and type of investment made, but for the sake of this discussion, it is enough to understand that an existing investment is an asset on the balance sheet and profit from the trade of an investment should be reported as profit (or loss) on the income statement.
As with most regulatory environments, it is not a one-size-fits-all model. There are various situations where capital gains taxes can be reduced through understanding the legislation and reporting accurately and strategically.
A few examples of potential reductions or deferrals in capital gains reporting include:
The dollar return of a security is the difference between the initial and ending value. Finding the dollar return for securities that trade in open markets is a matter of finding the difference in price from year to year.
IN CONTEXT
Consider a scenario in which a $100 security earns a stated return of 5% per year.
$100 security Year 1 Year 2 Year 3 Year 4 Rate of Return 5% 5% 5% 5% Geometric Average at End of Year 5% 5% 5% 5% Capital at End of Year $105.00 $110.25 $115.76 $121.55 Dollar Profit/Loss $5.00 $10.25 $15.76 $21.55
At the end of year 1, it is worth $105, which is $5 more than $100 (its value at the beginning of Year 1), so the dollar return is $5. The capital value at the end of Year 2 is $110.25, which is $5.25 more than at the end of Year 1, and $10.25 more than at the beginning of Year 1. Therefore, the dollar gain is $10.25. This continues for each successive year.
EXAMPLE
Suppose an investor has two investment options, both of which promise a dollar return of $1,000,000. They cannot tell which option is better without knowing additional details such as the risk or how long it will take to realize the returns. If the first option has a $1,000,000 return over two years and the other has a $1,000,000 return over 10 years, the first option is clearly more attractive.Dollar returns are valuable for comparing the nominal differences in investments. If two investments have similar profiles (risk, duration, etc.), then dollar returns are a useful way to compare them. The investor will always choose the option with the higher dollar return. Furthermore, the dollar return is useful because it provides an idea about how the assets of a firm will change.
EXAMPLE
If a firm is looking for an additional $50,000 from investment, they will only accept investments with a $50,000 dollar return, regardless of the percent return.The conventional way to express the return on a security (and investments in general) is in percentage terms. This is because it does not only matter how much money was earned on the investment, it matters how much was earned in proportion to the cost.
There are two types of percentage returns:
The total percentage return is based on the final value (Vf), the initial value (VI), and all dividend payments or additional incomes (D). If the investment is a security such as a stock, the final value is the sales price, the initial value is the purchase price, and D is the sum of all dividends received.
This type of return is also called the return on investment (ROI), where the numerator is the dollar return. The ROI is calculated for each individual year by dividing the dollar return by the initial value.
Let's look at an example:
$1,000 investment | Year 1 | Year 2 | Year 3 | Year 4 |
---|---|---|---|---|
Dollar Return | $100 | $55 | $60 | $50 |
ROI | 10% | 5.5% | 6% | 5% |
In this case, the ROI is the percentage return and is calculated by dividing the dollar return by the initial value of the investment of $1,000.
Annual returns show the percentage by which the value of the asset changes in each individual year. The average annual percentage return of an investment can be calculated with the following three methods:
Historical analysis of markets and of specific securities is a useful tool for investors, but it does not predict the future of the market. There are general trends and expectations of future behavior, but they are just generalizations.
EXAMPLE
The Dow Jones Industrial Average has generally increased overall since 1900, but its past performance is not a guarantee of future performance, such as the market crash of 1929.Inherent in all markets is something called systemic risk. Systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group, or component of a system. Macroeconomic forces, such as the Great Depression, affect the entire stock market and can’t be predicted from past market performance. The failure of one company affects all the companies who purchase from it or sell to it, which in turn affects all the companies that rely on them. These types of interlinkages are a cause of the overall market variability and volatility.
Furthermore, market variability and volatility can be the cause of what John Maynard Keynes called animal spirits. Animal spirits are the emotions felt by investors who affect markets. Expectations of investors affect how they act, which in turn affects the markets. If investors are feeling optimistic, for example, the market may go up, even without an improvement in the financials of the underlying companies.
Markets and stocks are affected by many factors beyond the information in their financial statements and past performance. Historical returns may provide an idea of the overall trend but certainly are not enough to accurately predict future performance.
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