RATES OF RETURN
Financial professionals understand what is meant by a rate of return on an investment. The language, calculations and methods of presentation make it nearly impossible for most people to figure and, even more elusive, to compare. The purpose of this article is for awareness more than about the details. My advice to you is to read the article and get a general understanding without running the numbers.
Consider this: If you had an investment that had the following Yearly Total Returns
| Year 1: +15% |
| Year 2: -50% |
| Year 3: +50% |
What would your return have been? Try guessing! Most people guess an Average Return (add them up and divide by three), giving you a return of +5%.
Look at it this way, based on a $100 investment,
| First year: $100 grows to $115 |
| Second year $115 decreases to $57.50 |
| Third year $57.50 grows to $86.25 |
The Holding Period Return (the time from the beginning of the first year to the end of the third year)
APR, (the Average Compounded Annual Percentage Return)
| This is the method that most people are most comfortable with and which seems to be the most commonly understood. It is easily comparable to what you could earn in a bank on a CD (Certificate of Deposit). The APR is also known as the IRR (Internal Rate of Return). It is also sometimes referred to as the Time-Weighted Return. To figure all the APR or IRR requires the use of a financial calculator and results in a return of -4.81%. |
The confusion does not end there. Let’s look at some other methods of calculation:
Total Return (Cash flow plus profit or minus loss)
| Cash flow (aka yield) is money that an investment distributes with some degree of reliability. Depending on the type of investment, it is called dividend (paid by stocks and mutual funds), interest (paid by banks and bonds) or net rents (from rental real estate). |
| Profit or Loss (aka capital gain or capital loss) is the difference between the amount paid to purchase the investment (plus additional purchases or improvements) compared to the proceeds after the sale of the investment. |
Now think about this:
| If you own a stock in a brokerage account, you subtract the sale proceeds (or current market value) from the amount paid and divide by the amount paid to calculate the return. Or do you? |
| If you do you have calculated the Holding Period Return for the capital gain or loss only.
What about the dividends paid along the way?
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So what if you want the Total Return expressed as an Average Annual Return
| Add up cash flow (yield) paid during the holding period |
| Add that to the gain or loss |
| Divide by the number of years you held the investment. |
As you can see, this is still not comparable to the IRR or APR and could result in a large misinterpretation of your investment success. To truly gauge your success requires, again, a financial calculator.
Timing makes a major difference as well. Let’s look at two scenarios and their results
| Both investors |
| | invested $1,000,000 | | used the same investment manager who | | invested in exactly the same amount in the same investments. |
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| Here is the difference: |
| | Investor One: Gave all $1,000,000 to the manager on Jan 1 and cashed in on Dec 31 | | Investor Two: Gives only $500,000 to manager on Jan 1 and kept the other $500,000 under his mattress until July 1 when he delivered it to the manager. Like Investor One, he cashed all in on Dec 31. | |
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For this example, let’s assume the manager’s investments achieved +50% in the first half of the year and
-50% in the second half. For the year, the manager seems to have a -0-% (Average, see above) return.
But what about the investors’ returns?
| Investor One ends up with -25% |
| | This is the actual year’s Holding Period Return, and because the period is exactly a year, it is also the APR or IRR (Time-Weighted Rate of Return). |
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| Investor Two got - 37.50% IRR |
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Did the manager do a better job selecting the investments that returned -0-% Average return, or for Investor One who earned -25% or for Investor Two who earned -37.5%? Only a more sophisticated and complex return calculation called the Dollar-Weighted Rate of Return (reported by investment managers to each investor) would show the performance of the manager to be the same in all three cases. This calculation factors out the timing of the investor’s contributions or withdrawals, upon which the evaluation of the manager is irrelevant.
Investor One’s simple return was better because he had more money invested while the market was up and less money while the market was down. How much you have invested when is the key.
How the Press Reports Returns vs. Your Return
| This helps explain why the returns reported in the press may not be your return. This is especially true for mutual funds or any investment where you add the cash flow (reinvestment) to the account or make an occasional withdrawal. Many simply defer to a financial publication to see what the fund return was. However, with the return on mutual funds, it’s important to make a distinction between the Time-Weighted Return (IRR) for selected periods of time, presented on performance charts, and the Dollar-Weighted Returns, which tells what you actually earned on the money that you had invested when you invested it; the two can be dramatically different. |
| Did you have all the money invested during the same time period reported with no additions, reinvestments or withdrawals? If so, your return is equal to the return on the performance chart. If not, your return would be as far off as the above Investors that had the same manager.
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So if you are now confused, call me and let me give you an in-depth explain of these concepts FOR YOUR INVESTMENT PORTFOLIO.