Calculating Performance

Key Takeaways

  • In what context should we consider performance?
  • Avoid the most common mistake
  • You can do-it-yourself to approximate performance

The Role of performance

The investment industry has historically focused on performance and little else, but there is so much more to client satisfaction than just a number. As we have previously written, investment performance comes at a price–and the price is risk. If an investment pays you more than a “risk free” Treasury bill or government bond–it must do so to compensate you for the additional risk inherent in that investment.

The wealth management profession has long been at the forefront of changing investors’ performance-only mindset. Rather than focusing solely on the performance of a portfolio, wealth managers focus on how a client’s portfolio tracks their risk tolerance and long-term financial plan and goals. Why compare your portfolio to an arbitrary index such as the Dow or the S&P 500?  An intelligent investor will take the least amount of risk necessary to achieve one’s long-term goals.

Now for the numbers

Don’t panic. We won’t get into complex math here. But when it comes to calculating investment returns it is important to understand the basic calculations involved so you can avoid common pitfalls about performance evaluation. We’ll use an example to make it easier.

Imagine that Sam begins the year with a portfolio valued at $100,000. At year’s end, the portfolio is worth $109,000—i.e. $9,000 more. Also assume he made no additions or withdrawals during the year. How did Sam’s portfolio do?  Divide $109,000 by $100,000, and you get 1.09.  Subtract 1 and you have .09.  Multiply .09 by 100, add a % sign, and Sam had a 9% increase.  We have all performed these simple calculations before, but let’s make it a little more realistic…and more complex.

Common mistake

Assume the same information as above, but now assume Sam had invested $5,000 into the portfolio at some point during the year. This means his investments didn’t really appreciate by $9,000 (i.e. 9%), since more than half of that increase was due to the $5,000 in new funds that Sam added. If we use the calculations above, even if stock prices were flat, Sam’s contribution would have resulted in a 5 percent increase. We know that can’t be the correct way to measure his yearly return.

Solutions

If you make intra-year contributions or withdrawals at various times during the year, it suddenly becomes difficult to calculate your actual return. Ideally, you could use a portfolio management program to calculate the rate of return or ask your financial advisor to calculate it for you.

 Do-it-yourself

You can also use your basic calculator to get an approximate rate of return. To compensate for the error we made in the example above, take the portfolio’s year-end value and subtract half of the net additions. Divide this number by the portfolio’s beginning value, to which you add half the net additions. Using the example above, the calculations would look like this: ($109,000 minus $2,500 i.e. $106,500) divided by ($100,000 plus $2,500 i.e. $102,500) equals 1.039. Subtract 1, multiply by 100, add the % sign, and you have a very good estimate at a 3.9% gain.

 

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Conclusion

Performance is important. It helps us evaluate investments and managers, but it’s much more important to view performance within the context of your financial plan and your goals. Please Contact us any time (610.695.8070) if you have a question about performance or its role in your financial plan.

Performance calculations and return assumptions are purely hypothetical and made for illustrative purposes only.  Actual client returns will vary based on various factors such as investment strategy chosen and underlying market conditions.

About Mark Rioboli

Mark A. Rioboli, CFP®, CFS is Director of Wealth Management for Independence Advisors, bringing over 25 years of experience in the wealth management industry. Have a question for Mark? CLICK HERE TO ASK MARK

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