Tracking and monitoring your portfolio's rate of return is imperative. But calculating the true rate of return on your investments is not as simple as you might think.
As a cautionary tale, just look at the Beardstown Business and Professional Women's Investment Club, which shot to fame around the world for nearly doubling the rate of return of the Dow Jones industrialized average for almost a decade, until it was revealed in 1998 that they had included new contributions as part of those returns.
An audit showed that the club actually lagged behind the index during that time. They simply didn't know how to calculate their portfolio's performance.
Take a look at your last statement from your financial institution. If you are provided with an overall portfolio rate of return, you're in the minority.
You might think that calculating the overall dollar gain as a percentage of the year's starting balance would suffice. But that only works if you haven't contributed or withdrawn money from your investment accounts.
Most people use the terms "investment management" and "portfolio management" interchangeably, but they're not the same thing.
Investment management is the selection and analysis of individual investments. You are trying to answer the question: Is this stock, bond or fund a good investment? There is no shortage of information to help you make these decisions: Price/earnings ratios, 52-week price charts, financial statements, analyst ratings, press releases and news articles are readily available through online investment-tracking tools.
Portfolio management, on the other hand, refers to the overseeing of all the individual investment selections working together. You are trying to answer such questions as: Do I have too much of a domestic bias? Is this potential addition to the portfolio negatively correlated to what I already have?
To monitor your investments, find an appropriate benchmark for the different parts of your portfolio. If 70 per cent of your portfolio is Canadian stocks and 30 per cent is U.S. stocks, your overall benchmark is a blend of 70 per cent of the performance of the Canadian market and 30 per cent of the performance of the U.S. market over the same time period.
The significance of performance is tied to the duration of the period you are looking at. One quarter is basically a crapshoot for any investment, but five years of sub-benchmark performance is certainly cause for concern.
If you are an active trader, you may want to create your own benchmark (e.g. +10 per cent a year), especially if you believe you can make a positive return in any market. You should also compare it to the indexes to help gauge whether the time and effort is worthwhile.
If you have an adviser, ask for an investment policy statement, or create your own. It should describe your investment philosophy and prescribe actions to take for various market scenarios ahead of time. A well-thought-out IPS enables you to be proactive rather than reactive when market events threaten to shake your resolve.
Time-weighted returns v dollar-weighted returns
Let's assume that a portfolio has three years of 20-per-cent annual returns, followed by three years of 0-per-cent annual returns. The time-weighted return is 10 per cent on average for those six years. But this is not accurate if you only invested $1 at the beginning, and then added $100,000 at the start of year four.
The end value of this portfolio after six years would be less than $100,002, because while the $1 grew at 20 per cent per year for three years, the $100,000 didn't grow at all.
The dollar-weighted return in this case would be virtually nothing. That's in stark contrast to the time-weighted average return of 10 per cent a year.
Time-weighted returns can help you figure out whether the investment was a good one in hindsight, but dollar-weighted returns will help you figure out how well you are actually deploying your money in those investments.
Preet Banerjee is the W Network's Money Expert and a senior vice-president with Pro-Financial Asset Management. His website is wheredoesallmymoneygo.com.