|Bowser in the Snow|
Over decades, a small under-performance can subtract a lot from a portfolio.
Thankfully, the portfolio calculation is getting easier by the minute. The technology that does all the work is spreading. In fact, a recent post on Schwab's Performance Calculator described how easy it is to get performance for both portfolios and benchmarks at their site.
Still, as a member in good standing of the "although I can multiple 2 numbers using a calculator it is still worth knowing how to do without a calculator" fraternity, I think those investors not totally allergic to math should know how to calculate performance. Again, with today's technology this is easy.
To begin, pick out the accounts you need to do the calculation for. This is easy on most discount brokerage sites. For example, if you have 5 accounts (2 brokerage accounts, a Roth IRA, and 2 traditional IRAs) and you just want to track performance for the IRAs, you can set up a grouping for these 3 accounts and call it "IRAs" or even "My IRAs"(pretty clever naming, huh?). If you want, of course, you can do the calculation for all accounts.
If there are no additions or withdrawals to the accounts, all we need to do is divide the ending portfolio value by the beginning value. For example, if the accounts totaled $1,000 and now are at $1,200, we've made 20%--we're doing great!
Actually not so fast - hold the smiley face. If the benchmark (passive portfolio we are comparing ourselves against that is typically made up of market indices) is up 30%, we actually haven't done that great.
But what about cash in and cash out? Maybe we deposited $200 into one of the IRAs! This is where the concept of time-weighted return (TWR) comes into play. The trick is to calculate return to the point before the deposit and then calculate return starting from the point after the deposit and multiply them. This is called linking. This approach measures how the investment performed and is independent of the cash flows.
Let's look at a simple example:
Start with $1000 and assume it grows to $1150, at which point you put in $300 and it grows to $1725. What is your TWR? Easy:
1150/1000 = 1.15
1725/1450 (we've added the 300 deposit to the 1150) = 1.19.
Multiply and get 1.3685 and the TWR is 36.85%.
To go one step further, suppose this was over a 2-year period. Then you may want to convert to an average annualized return. This is easy: just take the .5 root of 1.3685 and get 1.169. Thus, on an average annualized basis, you made 16.9%.
A little bit of thought reveals that some care needs to be taken when looking at TWR. Suppose you start with $1,000 and it increases to $1,200, at which point a deposit of $10,000 is made and at the end of the period the portfolio is $11,200. You made a 20% return on the smaller amount and a 0% return once the $10,000 was in the account.
For my clients, I handle all of this very simply. I get daily valuations of portfolios. This actually only takes a few minutes a day. Then at the end of the month, I look at the history of the accounts (again only a few minutes); and if there are withdrawals or additions, I make the adjustments. If the client is with Schwab, of course, I don't have to worry about any of this.