Return OF Capital vs. Return ON Capital

Closely followed by the return ON capital.  However, all that gets discussed is the latter of the two, return ON capital.  Why is that the case?  I’ll explain in more detail later, but first I want to make sure we’re all on the same page with what each of these terms mean.

So, to start, return OF capital talks about your original investment.  If you were to deposit $100 in an investment account, then that $100 would be considered your original investment or capital. Therefore, when you invest that $100, return OF capital refers to giving you back your money—or that initial $100.

Now, compare that to return ON capital, and the word “return” takes on a slightly different meaning.  Before, it related to giving you back your money, or capital; where here, it means the amount of money you earned on the investment.

For example, let’s say you made 10% on your investment, meaning your account is worth the $100 original investment plus 10% (or $10)—for a total return of $110. When that total amount is “returned” to you, then you receive a $100 for return OF capital, and $10 for return ON capital. Now granted, this is a very basic calculation; but it should still give you a good idea of what these terms represent.

Now that we’ve clarified this, let’s discuss the issues that lie between these important concepts.  Because as we listen to financial shows and read various financial newsletters/blogs, they all have a tendency of only talking about how to generate return ON capital; but rarely (if ever) discuss the risk of getting your money back, or the return OF capital. 

It has become a foregone conclusion among most experts that you simply “win some and you lose some.” Though, not necessarily wrong, this can quickly become a very dangerous thought process.

What do I mean by that?

It’s clear that investing involves losses. This aspect of investing is simply unavoidable because none of us have the foresight to know what tomorrow holds.  However, the fact remains that we must concentrate first and foremost, on protecting our investment or capital; or as stated here—our return OF capital.

Which ultimately brings us to the bigger issue facing today’s market: volatility.

As the market gyrates up and down that is called volatility. Increased volatility, or increased moves (up or down), is risk to the investor; because it risks your ability to get your money back. We don't know when the next market downturn is going to happen; nor do we know how long it will stay down. And the same goes for upturns in the market, but I'm sure you won't find any complaints there.

Unfortunately, the ugly truth of the matter is that you can't have upturns without the downturns. But the real kicker stems from the fact that if it the market downturns at the wrong time, then life goals and life's work can be ruined or put on hold.

For example, think of those set to retire on December 31st, 2008. After decades of work, you finally saved up enough for retirement and set your date. As you get closer, or about five months out, the market is at a near all-time high (at that point in history), and you're feeling great about your investments.

Then, one month later, you watch the market see one of the worst downturns since the great depression—destroying your life's work/savings. And less than 120 days later, you're left with only half of the money you originally set aside.

Now, let's think about this just a bit more.

Because not only did it wipe away the value of your portfolio, but for nearly five years after 2008—you got exactly zero extra money. Essentially, every dollar earned was to help re-build what was lost, for that period. So, it cost nearly five years of life and even more hard work—just to fight to get back what you already had.