Sources of return, total return, and interest on interest

Publisher Summary This chapter discusses the sources of return, how they are determined, and the assumptions required to use the process, and the results one might expect from using the process. The concept of total return is defined and developed. The interest rate (nominal annual rate compounded semiannually) that equates the present value of the final amount with the amount originally invested is called the rate of total return. The final, or total, amount in the fund includes the interest earned on the original investments, the interest earned on the reinvested interest, and the capital gain or loss when the investments mature or are sold at the end of the horizon. An investment fund has earnings from three sources: the interest earned, the interest on interest, and the capital gain or loss when the bonds mature or are sold, or the fund is dissolved. As the investment horizon increases, reinvestment rate generally becomes increasingly more important, and capital gain or loss becomes increasingly less important.