Investment Returns and Dividends

You can't judge a return in a vacuum. A fund that gained 8% had a great year if the market was flat and a poor one if the market rose 20%, so investors measure performance against a benchmark, a standard index that represents some slice of the market. A handful of these come up again and again on the exam, and the detail it tests most is how each one is weighted.

The major U.S. stock indices worth knowing:

• Dow Jones Industrial Average (DJIA): 30 large-cap U.S. stocks, and the oddball of the group because it is price-weighted. A higher-priced stock sways the average more than a lower-priced one, regardless of how big the two companies actually are.
• S&P 500: 500 large-cap U.S. stocks, market-cap weighted so the largest companies carry the most influence. It is widely treated as the best single gauge of the U.S. market.
• Nasdaq Composite: every stock listed on Nasdaq, market-cap weighted and heavily tilted toward technology.
• Russell 2000: 2,000 small-cap stocks, the standard benchmark for small-company performance.
• Wilshire 5000: the broadest of them all, built to capture essentially the entire U.S. stock market.

If you remember one contrast here, make it this: the DJIA is price-weighted, while the S&P 500, Nasdaq, and Russell are all market-cap weighted.

Before you can say whether an investment made money, you need to know what you paid for it. That figure is your cost basis, and it is the number the IRS compares against your sale price to decide your taxable gain or loss. Basis is not always just the purchase price, though. Several events adjust it over time:

• Stock splits: a 2-for-1 split doubles your shares and halves the cost per share. Your total basis does not change, it just spreads across more shares.
• Stock dividends: like a small split, the extra shares lower your per-share basis while leaving the total intact.
• Return of capital: a distribution that is partly your own money coming back reduces your basis rather than counting as income.
• Reinvested dividends: each reinvestment buys more shares and adds to your total basis, since you already paid tax on that dividend and it now counts as new money invested.
• Disallowed wash sale losses: a loss the wash sale rule defers gets added to the basis of the replacement shares.

Where return comes from

Every dollar an investment earns you arrives through one of three channels: interest from debt securities, dividends from stocks, and capital gains from selling something for more than you paid. A gain you have actually locked in by selling is realized; a gain that exists only on paper while you still hold the position is unrealized.

Total return

Total return pulls those pieces together. It combines the price change, up or down, with the income you collected, then states the result as a percentage of what you originally invested. Because it counts both the income and the appreciation, it is the most complete measure of how an investment performed, and it is the version the exam wants when it simply says return.

The SIE leans on a small set of return formulas, and they reward you for keeping the inputs straight, especially the difference between annual and periodic income.

Current yield

Current yield = annual income ÷ current market price. A bond paying $50 a year and trading at $900 has a current yield of $50 ÷ $900, or about 5.56%.

Dividend yield

Dividend yield = annual dividend per share ÷ market price per share. A stock at $80 paying a $2.40 annual dividend yields $2.40 ÷ $80, or 3.0%. If a question quotes the dividend per quarter, annualize it first by multiplying by four.

Total return

Total return = (income + capital appreciation) ÷ original investment. Buy at $50, collect $2 in dividends, and sell at $56, and your total return is ($2 + $6) ÷ $50, which is 16%.

Real rate of return

Real return = nominal return − inflation rate. An 8% return in a year of 3% inflation leaves a real return of roughly 5%, the part that actually grew your purchasing power.

A dividend is not handed to whoever happens to hold the stock on the day it pays out. The company sets a cutoff, and four dates govern who qualifies and when the money arrives.

• Declaration date: the board of directors votes to pay a dividend and announces the amount and the schedule.
• Ex-dividend date: the first day the stock trades without the right to the upcoming dividend. Buy on this day and the dividend belongs to the seller, not you. It is set by FINRA, not by the company.
• Record date: the day you must be on the company's books as a shareholder to receive the dividend.
• Payable date: the day the company actually pays the dividend to qualifying shareholders.

Here is the part that recently changed. Since the market moved to T+1 settlement in 2024, a regular-way trade settles one business day after the trade date, which lines the ex-dividend date up on the same business day as the record date. Under the old T+2 cycle, the ex-date fell one business day before the record date. The practical rule the exam cares about has not changed: to receive the dividend you must buy before the ex-date, which means buying at least one business day before the record date so the trade settles in time.

One more detail the exam likes: on the ex-dividend date a stock's price typically opens lower by roughly the amount of the dividend, since a buyer that morning is no longer purchasing the right to that payment.

The exam expects you to sort investment income into tax buckets, because the rate depends entirely on what kind of income it is and, for some of it, how long you held the asset.

Ordinary income (taxed at the highest rates)

• Interest from corporate and agency bonds
• Non-qualified dividends, such as those from REITs and money market funds
• Short-term capital gains on assets held one year or less
• The earnings portion of annuity withdrawals and traditional IRA distributions

Qualified dividends and long-term capital gains (taxed at 0%, 15%, or 20%)

These two share the same favorable rate schedule. A dividend is qualified when it comes from a U.S. or qualified foreign corporation and you held the stock long enough, at least 61 days during the 121-day window centered on the ex-dividend date. A long-term capital gain is a gain on an asset held more than one year, the familiar one-year-and-a-day threshold. Miss either holding period and the income drops back into the ordinary-income bucket.

Tax-exempt income

Interest on municipal bonds is exempt from federal income tax, and often from state tax for in-state residents, which is why munis appeal most to investors in high tax brackets.

When you sell only part of a position, which shares you are deemed to have sold determines your taxable gain, so the IRS recognizes a few cost basis methods.

Specific identification

You name the exact shares to sell. This gives the most control for tax planning, since you can choose high-cost shares to keep a gain small.

First-in, first-out (FIFO)

The default for stocks when you do not specify. The earliest shares you bought are treated as the first ones sold, which in a rising market usually means selling your lowest-cost shares and reporting the largest taxable gain.

Average cost

Available for mutual fund shares only. You divide the total cost of all shares by the number of shares to get a single average basis, simpler to track but with less room for tax planning.

The wash sale rule

If you sell a security at a loss and buy back a substantially identical security within 30 days before or after the sale, a 61-day window in total, the loss is disallowed for now. It is not gone for good: the disallowed amount is added to the cost basis of the replacement shares, so you recover it later through a smaller gain or larger loss.

The phrase that trips people up is substantially identical. Repurchasing the same stock triggers the rule, and so does buying call options on that same stock, because they represent the same security. Buying the stock of a different company, even a direct competitor in the same industry, does not trigger it, because that is not substantially identical.