• Zack Gutches

How Do I Know If My Investments Are Doing Good Or Not?

Remember in high school when your teacher told you about the power of compounding interest? If you just saved $1,000 every year and invested it each year for 40 years you'd have about $500,000 at the end?

But do you as a millennial ever feel like you look at your investment portfolio (401K, IRA, 403b, taxable brokerage accounts, etc.) and it just doesn't feel like your investments are going up that much? Everybody keeps talking about how good the market has been the past 10 years -- averaging over 13% a year (as represented by S&P500 index). Maybe you had $10,000 in 2009, and you know you've put in $1,000 a year for the past 10 years, but your investment isn't anywhere close to what you calculate it on paper to be ($52,365 to be exact).

Consider this: Maybe you're looking at the wrong investment return percentage.

Did you know? There are numerous ways to calculate investment return...Basic, Time-Weighted, and Dollar-Weighted. I can almost guarantee you the one you're looking at is Time-weighted. Let's talk about them a bit in simplest terms:

1) Basic: The simple one. You know, where you had $10,000 at the start of the year, and by the end of the year you had $12,000 -- so your return was 20% ($2,000 gain on $10,000 initial investment). Note: the calculation I did above assumes no cash flows in and out of the investment account. You can still do a Basic return % even if there are cash flows (I'll provide an example in a minute). But for now, let's talk about cash flows in and out...

In the real world, you're constantly putting money in or taking money out of your accounts throughout the year. So how do we account for that when measuring investment return? Keep reading…

2) Time-Weighted: This is the one you will always see by default on Vanguard, Schwab, etc. and there's a good reason for it (compliance shenanigans and comparison purposes -- more later). But my main point today is, maybe you shouldn't just be looking at this one. Here's why: it does not incorporate the VALUE in the portfolio (i.e. the amount of dollars). So if you invested $1 in January and January's return was +50%, then invested $100,000 in February and February's was -90%, it wouldn't consider the end VALUE of your portfolio (it would only look at the 50% and -90% when figuring out your return). This is why when looking at your portfolio's investment return, YOU HAVE TO ALSO CONSIDER DOLLAR-WEIGHTED RETURN.

3) Dollar-Weighted: Also referred to as Money-weighted return, IRR, or personal rate of return. ASK FOR THIS ON YOUR PORTFOLIO. It looks at timing of cash flows in and out, and how much $ the cash flows were each time and the impact on your portfolio's performance. What you find might surprise you.

Let's look at a quick example:

January 1, 2017: You invest $100,000 in stock Z (stock Z trades at $10/share, so you bought 10,000 shares).

July 1, 2017: stock Z is trading at $20/share (so it's up 100% from original $10/share). This means your portfolio is worth $200,000 ($20/share x 10,000 shares).

You're loving the ride and it's almost the 4th of July holiday, so you invest $200,000 more in stock Z (so you bought 10,000 more shares -- $200,000 divided by $20/share). Now you have $400,000 in your portfolio ($200,000 value from original stock Z purchase plus the additional $200,000 you just put in) and you now own 20,000 shares of stock Z (10,000 originally plus additional 10,000 just bought).

December 31, 2017: Your portfolio value is $240,000 (which means stock Z is trading at $12/share -- $240,000 divided by 20,000 shares). In other words, your portfolio dropped 40% since being valued at $400,000 on July 1.

Check out the difference in basic, time-weighted, and dollar-weighted. It will probably surprise you.

Basic: -20%. This makes sense; you contributed $300,000 ($100k initially plus $200k on July 1), but now your portfolio is at $240k (down from $300k -- a loss of $60k). And $60k / $300k = 20% loss.

Time-weighted: +20%. WHAT?!?! Yep. Think about it. Stock Z was originally $10 when you bought it. Now it's at $12. That's a 20% increase. This is what is generally reported when you look at your portfolio performance. Let's look at Dollar-Weighted now...

Dollar-weighted: -29%. When considering the timing and amount of your cash flows, this is what the actual return on your portfolio was. Although your initial $100k increased by 100% in the first half of the year, the second half decreased by 40% -- and the second half of the year is when you had way more money invested. So the second half of the year get's a higher weight (as it should).

Granted, these are extreme examples. But I'm illustrating a point. You need to look at all return %'s on your banking or investment account website. If you aren’t familiar with how to do this, I would suggest you talk to a financial professional who can help you and is on your personal side and knows you.

Why is it important to do this? I’m amazed at how many people don’t really care how well their portfolio is doing relative to the market’s performance. If the market is up 30% and their portfolio is up 10% they say something like “Well at least my portfolio is going up”. Okay yes that is true, but you’re missing out on so much extra return potentially. Again, we at Financially Forgotten Financial Coaching don’t teach you how you personally should invest or what to invest in specifically, but we can teach you about your portfolio – what it is doing or not doing, how it is performing relative to the overall market, and what levels of risk you are taking on (by mathematical standards). Maybe we could be the source just to help you figure out what you are actually invested in and what the profile of investments you are in actually mean in layman’s terms.

Now the question becomes -- why even use time-weighted at all? Well, it is helpful for comparing investments. It's the most unbiased way to look at this ETF vs that ETF, or stock Z from above versus some other stock -- because it's not subject to cash flow timing (which the managers of the ETF or mutual funds can't control -- so it works well for that). So, use time-weighted when looking at different investment options FOR your portfolio, but look at dollar-weighted (also called money-weighted or personal rate of return) when looking at your actual past portfolio performance.

These topics can get really complicated -- and I haven't even attempted to cover them all here (I actually ignored a lot of the intricacies).

If you would like an affordable, competent source of financial education and personal help with your individual finances (or just understanding them) we would love to hear about you and your situation. Waiting until you’re 60 to start understanding of and taking control of your finances is too late! Start now, while you are in your 20s and 30s – and build the skills you need to attain financial independence and learn what financial freedom is! We have a free 20 minute discovery call (a no-obligation, sales-pitch-free dialogue) available at https://www.financiallyforgotten.com/contact. Our affordable, transparent prices are also available for you to view at https://www.financiallyforgotten.com/pricing.

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