I read a lot about investments and investing. The word "return" has to rank among the top among terms I most frequently read. And believe it or not, when it comes to investment terms, the word "return" is among the most frequently misunderstood. Why? Because it's also among the most frequently abused.

Probably the single most important performance concept new investors need to get a handle on is investment return. Simply put, investment return the change in value of an asset over a given period of time.

Investment Return has two basic components:

1. Appreciation - an increase in the value of a stock or bond or other underlying security
2. Interest and/or Dividends - income generated by the underlying investment

By summing up all changes in value for specific assets or in aggregating them for an entire portfolio, investors can calculate the return on an asset or for the portfolio.

Now here's where it gets a little tricky, and where sometimes people selling investments take liberties with the idea of investment return. See, total returns can be expressed in different ways. Investment returns can be stated as the cumulative return over some particular period of time. Or they might be stated as an annualized return equivalent. It's not uncommon to use cumulative return for shorter time periods such as a month or a quarter. Annual return is the more acceptable way to state returns for time periods of more than one year.

Let's discuss how investment returns should be calculated.

The easy one is the cumulative return. The cumulative return on an investment should be calculated as the compounded rate of return which yields an overall investment value (the combination of asset appreciation and dividends and interest) at the end of the investment period. A rough order estimation of the cumulative return is the value of the investment at the end of a time period divided by the value at the beginning of the time period.

You can see why the cumulative return can be misleading to a degree. If the time period over which a cumulative investment return is calculated is sufficiently long and well chosen, the cumulative return on investment can be quite large. This is why it's better to evaluate longer term investments according to annualized returns

The annualized return on an investment is the annual percentage change in the value of that investment or portfolio that would yield the same end investment value as its associated cumulative return. In other words, the annual return, compounded each year for the full return evaluation period, equals the cumulative return for that same period. The annual return is computed using a mathematical formula that takes into account the compounding effect of gains and losses.

The graphic provides an example. Today's hypothetical $100,000 investment appreciates over three years to a little over $124,600. The cumulative return on that investment, using continuous compounding, is 22%. That return sounds pretty good, but it doesn't take into account that the increase in investment value took place over a period of 3 years.

A better assessment of return in this case is the annualized return. The equivalent annualized return on this investment is 7.33% continuously compounded over the 3 year period. That's quite a bit different from the very attractive sounding 22%, and probably less than you might think from looking at the table of individual annual returns which range from -8% on the low end to 18% on the high end.

Investors should work to understand how investment returns are calculated before putting money on the table. We are by nature, optimists. Otherwise we wouldn't be investing. But that optimism makes it easy for us to look at attractive returns and forget to ask how those returns are calculated. Always be aware of how the investment returns you're looking at are calculated before you invest.