A friend told me about his outstanding returns on an investment he made just after college. He had purchased 100 shares of Disney in 1999. When we were talking about this in March 2021, his returns were well above 500%. “I took less than three grand and it’s almost $19,000 now,” he said, “even with the theme parks closed due to COVID. Just wait until they can reopen.” I congratulated him and bought the next round of drinks.
But after I got home, his example kept bugging me. Is a 500% return good? Bad? Average?
Yeah, it sounded great. But since he had owned it for 22 years, I wondered if he had done as well as he thought. So I checked out some online calculators and discovered that through two major recessions, his stock had returned a respectable 8.94% per year. Not bad, but certainly not the huge return that you might have imagined.
Many brokers don’t provide the real number
While we were sitting in the beer garden enjoying the spring weather, he’d shown me his online account. Instead of providing an annual or personal return, his broker simply gave the total return. Unfortunately that’s the only number many brokers provide. While that’s valuable information for the first year, as you can see from above it loses impact the longer you own the investment.
Why it’s important to calculate your returns every year
The only way you can make informed decisions about your portfolio is to have…information. When you check your account balance and see that an investment is up 100% (or 557% with Disney), naturally you think that’s great. But like with Disney, unless you see the annual return you won’t know if you need to hold onto the stock or sell it for a better opportunity.
How to calculate your returns
Since many brokers won’t provide this information as part of your account, you may choose to do it yourself. Here are the formulas I use.
Return on investment. Return on investment (ROI) provides you a simple annual return, in this case where you made an investment and added no additional funds. Let’s assume you purchase 100 shares of ABC company on December 31 for $25.00 and sell the following December 31 for $37.25 per share. Simply take the ending value and subtract the beginning value ($3725-$2500=$1225), then divide by the beginning value ($1225/$2500=49%). Your return in one year was 49%. Nice job.
Compound annual growth rate. Compound annual growth rate (CAGR) provides you with investment returns for more than one year – again with no additional money invested in the stock during the time period. For this example, let’s look at the Disney stock. My friend invested a total of $2816.20 in 1999, and it grew to $18,522 in 2021. This has a few more steps, so here’s the actual formula with our example below it.
Annual Return = (Ending Value/Initial Value)(1/No Years) – 1
So: ($18,522/$2816.20)(1/22)-1 = 8.94%
Internal rate of return. The internal rate of return (IRR) is often used to calculate your personal rate of return that your fund company or broker may provide. This calculation can be used for one year or several years. IRR, also known as a dollar-weighted or money-weighted return, provides a more accurate measure of your actual investing activity (including dollars invested or withdrawn along the way). However, it’s also somewhat complicated. The easiest way to determine IRR is to use an online calculator. If you want to have an ongoing tally, see my information on how to set up an Excel spreadsheet for both IRR and time-weighted returns.
IRR assumes your money flow is constant. For instance, you send monthly contributions to an investment or perhaps invest every January 2 in your Roth IRA. For situations where you may send an amount randomly, you need to include the dates when you sent the money. (In Excel, you would use the XIRR function.)
Time-weighted returns. Quite often, mutual funds and other investment managers report their results as a time-weighted percentage. This in effect strips out any cash flow into or out of the portfolio or fund and provides a clear picture of the fund manager’s performance over time.
Is there one right answer?
You may have noticed that there are several formulas for what should be a hard and fast answer. In calculating returns, it’s more along the lines of as accurate as possible. Here’s a simple example:
- On Dec 1, an investor buys 1,000 shares of stock at $1 per share (spending $1,000).
- On Dec 1 the following year, they buy another 1,000 shares at $2 per share (spending $2,000).
- On Dec 1 the following year, they sell their 2,000 shares for the market price of $1.25 per share.
- In this example, the investor lost $500 ($3,000 invested, $2,500 received when they sold their shares).
Note that the money-weighted return is -12.77%, while the time-weighted return is 11.80%. Even though you lost money, the time-weighted return is positive. Think about this for a second. If you had invested a set amount in the stock in year 1, you would have made money; while the investment doubled to $2/share then dropped, the overall result was a positive share price ($1 grew to $1.25). It was the timing of your investments that turned the results negative, as you invested just before the shares dropped.
Given the above example, it’s imperative that you look at several different measures, especially if your broker isn’t providing a personalized rate of return. For those investments where you’re investing regularly, consider both your personal return and the time-weighted return (or the return reported by the investment itself).
Benchmarks
As you’re looking at your returns, you should keep in mind the benchmarks applicable to your particular investment. Overall, stocks have returned around 10% per year (before inflation) and bonds about half that. However, if you’re invested in small-cap stocks, you should use a small-cap index to determine if your investments have surpassed or underperformed. Many choose the Russell 2000. For more targeted ETFs and mutual funds, they will often provide the index they use to measure success.
Also, make sure you compare the time-weighted returns to the benchmark. Benchmark returns do not include your deposits and withdrawals, so you should use a comparison that also does not include these cash flows.
Once you set up a system, it will be easy to watch your portfolio over time. Use the resources you have – online calculators, spreadsheet programs, etc. – to minimize work on your end. And if you aren’t seeing an IRR or Personalized Return for your accounts, call your broker or fund company and ask why.
Photo by Tyler Easton