My Investments Are Doing Awesome (Or Terrible)…How Do You Know?

Transcript

How do you measure the performance of your investment accounts? Seems like a straightforward question that should be easy to answer, right? I hear people talk about their account performance all the time, usually in one of two ways. Either they admit they have no idea what their performance has been and are very interested in trying to figure it out. Or the other camp thinks they know exactly how they are doing. Although, I often find their perception of performance is far from reality.

Regardless of which camp you are in, this episode will not only teach you how to accurately determine the performance of your accounts, but probably even more importantly, evaluate that performance to make sure you are performing as you should be.

Welcome to the first season of Invested Poorly: Sad Tales of FInancial Fails, a short-form podcast designed to help everyday investors make wiser investment decisions by learning what NOT to do with their money. Host Jeff Harrell shares timeless stories from his former life as a financial advisor, about the poor—and irrational—choices he witnessed investors make that disrupted their journey to financial independence, or FI. Your ability to recognize, and avoid, similar mistakes could make all the difference for you along your path to reach FI.

Check out the “Introduction” episode for more background on Jeff, why he created this podcast, and how it can guide you to becoming the hero of your own investing story. Now, on with show.

Here is a quick story as to why understanding your performance is so important. I took a phone call from a client one time who was extremely upset because he believed he had not made any money in his investment account over the past year, despite the fact the stock market was up at least 10%. I was totally caught off guard by his comments because I knew we were having a good year, so what he was saying didn’t make any sense. I quickly brought up his accounts to see what might be going on.

I almost immediately noticed he had withdrawn around $300,000 eight or nine months ago, so I asked him if he remembered that withdrawal. His lack of response said it all. Now, I don’t know how you forget about withdrawing $300,000, but obviously he had. Ironically, this was pretty close to his gain for the year, so it made sense why he thought he hadn’t made any money.

To me, this story perfectly illustrates why whenever someone starts talking about their account performance, I like to dig deeper to find out if their perception of their performance is reality. The examples I’m about to go over will illustrate why it is a more complicated calculation than you might think.

In the simplest example, an investor starts with $10,000 in their account, and by the end of the year it is worth $13,000. If they didn’t add or subtract a penny during the year, the return is very easy to calculate. It would be 30%, or a $3,000 gain on a $10,000 investment. Unfortunately, the real world isn’t that simple because most of us have accounts with money going in and out, which obviously complicates the calculation. When you start thinking about cash flows, you realize you now have a problem using the simple calculation I just used.

Before I go any further, you need to be aware that you have a choice when it comes to calculating performance. Are you more interested in knowing your personal rate of return, which is influenced by cash flows going into or out of the account, or would you rather know your time-weighted rate of return, which negates the effect of cash flows? Okay, I realize this already sounds a little technical, so before I move on, let me try and explain the difference between the two.

Let’s assume you invested $5,000 to start the year and in the first six months you doubled it, turning it into $10,000. That’s a $5,000 gain on an original $5,000 investment, which is a 100% rate of return. Let’s say you then come into some extra money and decide to deposit $90,000, resulting in a total portfolio of $100,000 in the middle of the year. Over the next six months you lose $5,000, leaving you with a portfolio of $95,000 at the end of the year. Based on this example, what is your performance or rate of return? My answer is two-fold: 0% and 90%...What?!? How can I have two dramatically different results. Let me show you.

First, we will focus on your personal return, sometimes referred to as the internal rate of return or money-weighted return. This one is pretty straightforward. You invested $5,000 to start and $90,000 in the middle of the year. You ended the year with $95,000, so pretty easy to see how this is a 0% personal rate of return, since you didn’t make or lose any money. I doubt any of you are going to argue with me on this one.

Now let’s move on to the other return I quoted…90%, which is your time-weighted rate of return. I’m sure you are shaking your head, wondering what type of mumbo jumbo I’m going to come up with to convince you a 0% rate of return is actually a 90% rate of return. Follow along.

Back to the example of starting off with $5,000 and doubling it to $10,000 in the first six months, this resulted in a very easy to calculate 100% rate of return for the first six months of the year. After that you added $90,000, bringing the total account value to $100,000. You then lost $5,000, which is only a 5% loss of the $100,000 account value. From this perspective, I fail to see how a 100% return in the first half of the year followed by a 5% loss in the second half of the year is 0%. After all, if you would have started the year with $100,000 and doubled it, it would have grown to $200,000. The subsequent 5% loss would have resulted in a $10,000 decline in value, leaving you with $190,000. This hypothetical $190,000 compared to the hypothetical $100,000 investment, results in a return of 90%. I know, mind blown!!

Now, before you start to think I’m trying to use some type of Jedi mind trick to convince you that calculating a return using the time-weighted method is always higher than your personal return, let’s change a couple of variables to illustrate the difference. In this next example, we will say you started the year with $100,000 and then doubled it to $200,000; once again this is a 100% rate of return. But in this example, let’s now say you remove $190,000, leaving you with only a $10,000 portfolio, and you then lose 50% of this or $5,000. From a personal return standpoint, you have $190,000 of cash that you removed from the account plus the remaining account value of $5,000 for a total of $195,000. Since you started with $100,000, I’d call that a 95% personal rate of return; wouldn’t you? But if we now calculate the time-weighted return, we use the 100% return in the first six months, followed by the 50% decline over the next six months, resulting in a 0% rate of return.

Here are some numbers to illustrate the 100% return followed by a 50% decline. If you start the year with $100,000 and double it, you get to $200,000. If you then lose 50% or $100,000, it brings you right back to your original starting value of $100,000, resulting in a 0% rate of return.

I realize this is still probably a little confusing and you may need to listen to this episode a couple times to let it really sink in, but hopefully you now understand that cash flows have a huge impact on the calculation of performance. Over the years I would explain this to investors time and time again, but if I’m honest I really don’t think it resonated with many of them because investors are so fixated on their personal return.

I totally get it, the personal return is real profit or loss, and the time-weighted return is hypothetical, but you have to understand that if you are going to compare your return to a benchmark or index, you have to negate the effect of cash flows because the returns of the indexes are not affected by your personal cash flows. This is why both numbers are useful.

Again, I know this is a little complicated and if you are still trying to wrap your head around this, I would encourage you to follow my inquisitive little nephew’s advice and “search it up.”  You can find plenty of articles online that go over this in much greater detail than I just did.

The good news is both Schwab and Fidelity have very useful performance reporting features on their client websites that calculate both of these returns, so if you are using one of these brokers, I encourage you to check out these features. Honestly, I’m not sure how many other brokerage firms offer both of these calculations, but now that you know what you’re looking for when it comes to calculating performance, you can investigate for yourself. Okay, I think that’s more than enough math to cover in one day; class dismissed.

I sure hope you enjoyed this episode of Invested Poorly and will be able to take something from it to improve your decision making as you navigate the twists and turns of your personal investing adventure. Be sure to check out my website at AreYouFI.com (that’s A R E Y O U F I dot com) where you can find resources and show notes with the charts and graphs I mention during the episodes. These are like little treasure maps that can help you choose more wisely along your quest to reach FI, or financial independence.

Never forget, in the short-term the stock market is unpredictable, and as my mischievous little nephew likes to say, “things just happen”! So focus on the long-term, by controlling your emotions, simplify your investments, and always… ignore the noise.

I’m your host, Jeff Harrell.  Thanks for listening.

Invested Poorly: Sad Tales of FInancial Fails was created for informational purposes only and should not be relied on for specific tax, legal, or investment advice. You should consider consulting a qualified professional to review your situation before engaging in any transactions. Investing involves risk, including loss of principal and past performance is no guarantee of future results. 

This podcast was produced by Ted Cragg. Learn more about creating podcast mini-series like this by visiting QuickEditPodcasts.com.