In the last fifty years or so, performance calculations have come a long way. Part of this has been out of necessity - because investment vehicles have become more complicated. A much more significant part of this has been the rise of computers which have given us a greater ability to do complex math at the click of a button. What this means is that not only has calculating but also understanding investment returns have evolved into a much more in-depth process than you probably realize.
Prior to the 1960s, it was significantly easier to calculate performance because the bulk of investing was done in bonds which were less volatile back then. Because you only had to worry about income in the form of interest the calculation was simple. Today, we invest in a much more volatile environment and we’ve added a variety of instruments for investing that not only yield income but also appreciate making it that much harder when it comes time to figure out what your account has returned. When it comes down to it, there are several things that need to be considered, such as:
Deposits and Withdrawals
One of the easiest things people tend to overlook is the fact that most accounts experience incoming and outgoing cash flows either because they’re adding or subtracting money. This can make performance calculations difficult because you don’t want to treat a deposit as “positive” performance or a withdrawal as “negative” performance. The solution here is to use a calculation known as the Time-Weighted Return. This calculation is considered industry standard and is used by the majority of financial firms because it takes into account the timing of cash flows, making the performance number more accurate.
Income and Capital Appreciation
As previously mentioned, for the modern portfolio, it’s important to consider both income from dividends and interest, and capital appreciation from the movement of prices when calculating performance. This is because both contribute to the growth of your account and in order to have a holistic view of how well your account is doing you need to consider both in your calculation. The standard here is to use what’s known as Total Return which includes the return to your account from both income and appreciation.
Finally, it’s important to always consider fees when looking at the performance of your account. A good advisor is one who presents the performance of your account to you net of (after) fees. This is crucial because 2% in fees is the difference between a 5% return and a 3% return and an advisor that fails to show you your return above and beyond what they are charging you is sending a misleading message.
With the quarter-end just around the corner and with it your quarterly statements, we always encourage you to be engaged and involved in tracking your investment performance and ultimately, your success in meeting your financial goals. If you’d like to learn more about how to read your statement, please don’t hesitate to reach out.
Institute, CFA. 2016 CFA Level III Volume 6 Trading and Rebalancing, Performance Evaluation, and Global Investment Performance Standards. CFA Institute, 07/2015. VitalBook file.