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investor clinic

How can I figure out the rate of return on my portfolio?

Knowing your rate of return is crucial. Without it, you can't tell how your portfolio is performing or if you're on track to meet your investment goals. Unfortunately, many investors are in the dark when it comes to returns.

It's not their fault. The investment industry has done a terrible job of providing personalized performance information to clients.

The good news is that things are changing. Some fund companies and brokers provide detailed performance data, and under new rules adopted by the Canadian Securities Administrators (CSA), all investment firms will be required to provide an annual performance report that includes percentage returns over various periods.

The bad news is that firms have three years to comply.

That's where today's column comes in. I'll show you some relatively easy ways to compute the returns yourself. Don't worry: Most of the number crunching will be done by online calculators.

First things first: What is a return? Say you invest $10,000, and one year later your portfolio is worth $10,800. To calculate your return, subtract the initial value from the final value, and divide the result by the initial value. Your return would be $800/$10,000, which is 0.08, or 8 per cent.

Most return calculations aren't that simple, however. What if you added money to the portfolio during the year? That would throw the calculation off, because contributions shouldn't be counted as gains. The same goes for withdrawals: They're not the same as losses.

Fortunately, there are ways to compute returns that take into account the cash flowing in and out of a portfolio.

Weigh House Investor Services has an easy-to-use return calculator on its website. Simply enter the starting and ending dates and portfolio values, and any contributions and withdrawals during that period, and the calculator provides your average rate of return.

The Weigh House calculator computes what is known as the money-weighted rate of return, or internal rate of return. If you're handy with a spreadsheet such as Excel, you can use the XIRR function to do the same thing.

Why is it called a money-weighted return? An example will illustrate the concept. Say you buy a share of stock for $100. The stock falls 20 per cent in the first six months, then rises 25 per cent in the next six months. At the end of the year it's back to $100, for a return of zero.

Now consider if, after the first six months, you decide to buy a second share for $80 – just before the stock rebounds. After a year you would have $200, which is $20 more than your total investment of $180. So, even though the stock is back to where it started, the fact that your investment was more heavily "weighted" during the upturn means you come out ahead.

Similary, if you were to put more money in right before an investment headed south, it would have a negative effect on the money-weighted return. Under the new CSA rules, firms will be required to use money-weighted returns.

This method isn't ideal in every case, however, particularly when evaluating a portfolio manager. Consider a manager who has five years of good returns when his client's account is small, and then – after the client deposits a large sum of money from an inheritance, for example – has one bad year. The money-weighted return would look lousy because the account was largest during the market's worst period, but it wouldn't necessarily be fair to judge the manager on that basis.

Enter the time-weighted rate of return. This method strips out the impact of deposits and withdrawals to get at the "true" underlying rate of return. In practice, it requires calculating the portfolio's return on a daily basis, net of any inflows or outflows, and then linking these returns together to calculate performance over longer periods.

Yet another measure is the Modified Dietz rate of return. PWL Capital has an online Modified Dietz calculator, available here. (The 2012 calculator contains detailed instructions and can be used for leap years, but you'll need to use the 2013 calculator for non-leap years).

After being kept in the dark about returns for years, investors are starting to see the light. "There was a lot of interest" when the calculator was posted, said PWL portfolio manager Justin Bender. "My e-mail was flooded."

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