As a trader, I’m sure you want to see your portfolio grow over time. But you probably want to know how well your strategy is doing on a monthly, quarterly or annual basis as well.
And that begs two questions:
(1) How do I calculate the return on my portfolio? and
(2) Do I want to look at percentage increases or the total value of the portfolio?
Let’s take a look.
The answer to the first question is “It depends.” The answer to the second question is “Yes.”
First, there are many ways to calculate returns on a portfolio including the approximation method, internal rate of return (IRR) and time-weighted return (TWR). For our clients, we prefer the time-weighted method, but when you are trading for your own account your preference may differ.
The approximation method is a simple formula that uses information readily available from most brokerage or mutual fund statements. While not highly accurate, it will give you a close approximation about how your strategy is working. Here’s how it works.
For a specific period (month, quarter, year, etc.), the formula compares the ending value of the portfolio to its beginning value, then adjusts for additions and withdrawals by subtracting 50 percent of net additions from the end value and adding 50 percent of net additions to the beginning value. This creates a midpoint average for cash flows no matter when they occur during the period.
The IRR method is similar to the approximation method in that it too looks at cash flows into and out of the portfolio during a specific time period. The difference is that IRR measures portfolio performance using highly sophisticated mathematical equations to more accurately track the size and timing of cash flows.
The TWR method measures your performance by giving the same weight to every time period, without taking into account cash flows within the portfolio. In other words, you determine your investment returns based on “sub-periods” that occur up to an addition or withdrawal and those that occur immediately after additions or withdrawals. These sub-period returns are then linked together by adding 1 to each of their returns (expressed as a decimal) and multiplying the resulting factors.
Once you’ve calculated your performance, you’ll probably want to compare it to a benchmark to validate the original return assumptions you made to meet your long-term goals. This makes choosing the right benchmark critically important. For instance, if you have a balanced (60% equities, 40% fixed-income), globally allocated portfolio, using the Dow Jones Industrial Average or the S&P 500 as your benchmark doesn’t make much sense. So, to what do you compare your portfolio performance?
First, take the percentage that each asset class represents in your portfolio and multiply that by the total return on the appropriate index for each asset class. Then simply add these “weighted” returns together and that will give you an appropriate index by which to judge your actual returns. If you fall too far behind this index, you may need to adjust your allocation (both asset classes and individual securities).
Whatever method you choose to measure your performance is obviously up to you (maybe you’ll use all of them) and all have their pluses and minuses. But regardless of which one you choose, there are two things you should keep in mind: (1) Even though you can determine your performance over any period of time, always keep your eye on the long-term, and (2) Regardless of which method you choose, you should ultimately judge your success on an after-tax basis.
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David L. Blain is president and chief investment officer of D.L. Blain & Co. in New Bern, North Carolina. Reach him here via e-mail.