I just completed an annual ritual that involves calculating one of my favorite metrics, other than monthly expenses and net worth, and that is overall portfolio return. This is an exercise that I’ve performed annually for many years, and that I recommend to anybody who is seriously bent on financial independence and who really wants to understand the process of getting there.
I don’t monitor or track the performance of my individual holdings all that closely. Oh sure, I have a sense of how each is doing, from watching prices periodically. But I don’t worry much about individual funds, and certainly don’t obsess over performance at that level. I expect some holdings to be down when others are up, and vice-versa. That’s because many of the funds in my portfolio represent different asset classes, which I expect to display substantial variation in performance over time. So I really don’t worry about individual holdings, as long as I’m comfortable with the performance of my portfolio, as a whole — which I expect to show modest growth over the long haul.
Investor vs. Fund Returns
Why is it so important to track overall portfolio performance? Because it’s extremely easy to fool yourself or be misled, if you don’t crunch the actual numbers. A few notable gains, or losses, can distort your perception of your actual progress. It’s easy to dwell on your few successes and miss whether your portfolio is actually succeeding at your goals, or not.
For one thing, if you only watch prices and don’t look at your total returns annually, then it’s easy to miss the performance punch from steady dividends. And another, if you rely only on published performance numbers for your individual holdings, you won’t account for the impact of any trading you did during year. So it’s very important to analyze overall performance on an account-wide basis. Then you can make adjustments in your investing and planning, according to the reality of your results.
A study by Dalbar showed that, during a recent 20-year period when the S&P 500 experienced a 9.1% annual return, the average equity fund investor only achieved 3.8%. Why the difference? The average investor traded too much, staying in any single investment for only 3.3 years, on average. Some have disputed the Dalbar findings recently, but that doesn’t change the fact that you, personally, are at risk of underperforming the benchmarks if you trade frequently. So, the calculations I’m about to describe can alert you to your actual performance with cold, hard numbers.
How to Do It
Finding your actual, overall investment return could be very simple, or complex, depending on your situation.
First, understand that money you deposit or withdraw from your portfolio affects its value at year end, but isn’t part of the investment return. So an accurate calculation will exclude the impact of those deposits and withdrawals. It’s generally much easier to know the annual return if you don’t trade much and keep the same few accounts year after year — another argument for keeping your financial life simple. In general, the more, and the more complex, your accounts and transactions, the harder it will be to compute your overall performance. But the more important it will be. Because you are at risk for increased expenses and emotion-driven blunders that could damage your nest egg. Without computing your actual performance, you won’t have a compass to guide you.
With luck, your financial institutions will compute the overall return for each of your accounts, and provide it at the end of the year. So, if you have most of your assets in a single account, finding your overall return might be as easy as logging into a web site. However, if you have multiple accounts, or if your financial institution doesn’t compute an overall return, then you could be in for a lengthier number-crunching exercise….
How do you compute overall performance when you have accounts at multiple institutions? One approximation is to do a weighted average of the returns from all your different accounts. A weighted average is an average in which each quantity is assigned a weight according to its relative importance in the overall total.
To take a simple example, suppose you have just two acounts. One was worth $200,000 at the start of the year and had an 8% return . The second was worth $300,000 and had a 6% return for the year. You compute the weighted average return like this:
return = ((200000 * 8%) + (300000 * 6%))/(200000+300000) = 6.8%
That’s for combining the returns from different accounts.
If an institution didn’t compute your investment return for you within one account, and you didn’t have much deposit/withdrawal activity in that account for the year, then you can also calculate an approximation by looking up the annual returns for the individual funds or securities in the account, and calculating a weighted average of those. But, there is a better way….
More Accurate Approaches
The actual return that you experienced in your account could be dramatically different from the published returns for your holdings, if you’ve been buying and selling so that you owned certain positions for only part of the year. Worst case, if you are actively trading, you could even miss out on most of the returns in a given year. If you did have a lot of account activity, there is a straightforward formula (which I first encountered in The Four Pillars of Investing) for computing an approximate annual return, using your beginning and ending account balances plus net inflow/outflow. And, because this calculation uses your actual account balances, the impacts of dividends and any trading are included in the final number.
Before you start this calculation, be sure to have your account balances for the last business day of the past year, and for the year before that. (Note this will require updating security prices for the last business day of each year!)
The next step, finding net inflows and outflows, can be the most difficult or tedious part of the job, depending on the capabilities of your personal finance software or financial institution. You may need to work through your account statements, adding all your deposits and subtracting all your withdrawals to determine your net. (If you took out more money than you put in for the year, this number will be negative.)
Then, compute your return as follows:
return = (((end value – (net inflow/2)) / (beginning value + (net inflow/2))) – 1.0) * 100
Note this gives you the return for an individual account. You could then compute an overall weighted return for all the accounts in your portfolio, as described in the section above. Alternatively, you can sum the beginning/end values, and net inflows, for all your accounts and run those sums through the formula above. The results should be the same.
This formula assumes that additions and withdrawals occurred evenly throughout the year and were relatively small — less than about 10% of your portfolio. In my experience it generally gives sensible values, that only differ from my institutions or Quicken by a few tenths of a percent. In rare cases, generally when there were significant transactions in the year, I have seen larger differences of a few percent.
The most accurate calculation of return is known as the “internal rate of return” and it takes into consideration the timing of every single cash flow in or out of an account. This can be calculated with a financial calculator or computer software, but it’s laborious and error prone, if you must enter all your transactions manually. However it’s the only truly accurate method, if cash inflows and outflows have been substantial.
(In essence the formula given above creates an average midpoint for all the cash flows in or out of your account, regardless of when they actually occurred. It is most accurate when inflows and outflows are relatively periodic, balanced, and small.)
One of the clearest references I’ve found on this topic is from the American Association of Individual Investors and also discusses a more advanced technique for calculating portfolio returns, called the time-weighted return, which is able to filter the impact of the timing of the cash flows, and may be helpful for assessing the abilities (as opposed to luck) of whoever is managing the portfolio.
One Last Benefit: Your Savings Rate
A final benefit of computing your annual return is found when you add up all the inflows and outflows to your investment accounts and compute the net by substracting outflows from inflows. What is that number? Well, it’s simply your net savings for the year. This tells you how much money you put in to, or drew out of, your savings, independent of any investment returns.
During your accumulation years, that number should be positive and a substantial part of your income each year. The higher it is, as a percent of your income, the sooner you can retire. (During our best savings years, we were able to save about one-third of our income each year.)
This past year, for the first time, our net savings value turned negative. That’s because we are beginning to draw from our portfolio for retirement living expenses. However, at least for this past year, the amount we had to withdraw was only a small portion of the total growth in our portfolio for the year, meaning there is no imminent threat to our nest egg!