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The Portfolio Doctor

My blog provides valuable insights into Nobel Prize-winning financial strategies for investors. By utilizing decades of worldwide peer-reviewed capital markets research and analysis, I demonstrate how to build better investment portfolios with lower risks. I also examine common financial media misinformation and how investors can make better financial decisions.

What Investors Need to Understand About ‘Investment Return’

Learning the jargon of financial investment can be daunting, but it can also provide you with a better way to understand the status of your investments. Here is a brief primer on some common financial terms you should know, and things you should consider when evaluating your portfolio and investment returns.

(This article was written by Robert Powell and originally appeared in "The Wall Street Journal, April 9, 2017)

It pays to understand the different ways to calculate investment return, overcoming jargon.

At first blush, it seems simple enough. At the end of a 12-month period, you divide the ending balance of your 401(k) by the starting balance, and voilà. There is the one-year return.

But how much does that return really tell you?

There are several ways to measure investment returns, and each is used to highlight different things. Some focus on the total return of a portfolio inclusive of all investment activity, including distributions and contributions; some are used to gauge how well an adviser managed a client’s money.

Many professionals don’t make the subject easy for investors. Measures of returns are “full of jargon and difficult for folks to understand sometimes,” says Stephen Horan, managing director of credentialing at the CFA Institute, which awards a designation to advisers who pass the Certificate in Investment Performance Measurement, or CIPM, exam.

The jargon is worth learning, though. Investors who understand the different measures could make better decisions about their money.

Here are a few tips to help demystify the seemingly obtuse and impenetrable measures of investment returns.

Geometric vs. arithmetic average

To come up with a single number reflecting a return over multiple holding periods, some form of averaging is required. But arithmetic and geometric averages give different results, and professionals all use the geometric method. Here’s why.

The arithmetic average is the one we all learn in basic math class. Using it to calculate an average return for your portfolio over a multiyear period, one would add up the returns for each year and then divide by the number of years. But arithmetic averages capture neither the impact of compounding nor year-over-year volatility, Dr. Horan says. Professionals consider them a poor indicator of overall performance.

Say your portfolio rose 10.5% in year one, lost 3.6% in year two, rose 20.7% in year three, rose 6.4% in year four and rose 12.3% in year five. Using an arithmetic average, your average return is 9.26%.

Using a geometric average, the answer is 8.96%. The geometric mean reflects the investment’s or portfolio’s internal rate of return. The method applies compounding to the initial investment and to each cash flow.

what investors need chart

To be fair, arithmetic averages can represent useful estimates of single-period returns, says Dr. Horan. But an investment professional would never consider using the arithmetic average when presenting returns to the public.
It is “always misleading,” says Carl Bacon, an author and chairman of the Global Investment Performance Standards executive committee, the CFA Institute’s body responsible for overseeing and developing best practices for calculating and presenting investment performance.

Time-weighted vs. dollar-weighted

Two of the more common ways to measure investment returns are time-weighted and dollar-weighted.
A time-weighted return doesn’t factor in how much someone is depositing into or withdrawing from an investment account. It measures the performance of the investment from one point in time to another.

By contrast, the dollar-weighted return measures the total return of your portfolio inclusive of all cash inflows (contributions into your 401(k), for instance) and outflows (such as distributions or withdrawals). It can help an investor track the performance of a portfolio taking into account the effects of his or her financial behavior.
Todd Jankowski, head of the CFA Institute’s CIPM program, offers this example: Say you put $100,000 at the start of the year in a brokerage account, and your adviser invests it in a non-dividend-paying growth stock (1,000 shares at $100). At the end of year one, your investment is valued at $150,000 (1,000 shares at $150).

At the start of the second year, you decide to invest $900,000 more in the same stock (6,000 shares at $150). Due to a 50% drop in the stock’s value, however, your account’s value at the end of year two is $525,000, resulting in a 50% loss in year two.

Your two-year geometric annualized time-weighted return, which reflects the compounding effect, is minus 13.4%. This represents a cumulative 25% loss over two years, or 13.4% loss annualized, according to Mr. Jankowski.

Your dollar-weighted return, however, which is also referred to as the internal rate of return and reflects the impact of your contribution, would be minus 45.02%, says Mr. Jankowski.

To measure the portfolio manager’s performance, you would use the time-weighted method, which includes compounding but excludes contributions from the outside, like cash infusions. To measure the portfolio’s performance inclusive of the client’s decisions—including his ill-timed cash infusion—you would use money-weighted.

What else to consider?

Investors should also have some working knowledge of what’s called the effective annual return, or EAR. The EAR, according to Dr. Horan, simply means coming up with an equivalent to an annual return based on numbers from periods that constitute either less than a year or more than year.

“If the non-annual return is shorter than one year, it involves compounding the short-term return until it grows for a year,” he says. “And if the time period is greater than a year, it involves ‘averaging’ the return into a single year using the geometric average.”

This is done so investors can measure rates of return for different investments on an apples-to-apples basis. Otherwise it would be difficult to compare an investment that returned 6% compounded semiannually, which has an effective annual rate of 12.4%, with say an investment that returned 18% in 18 months, which would equate to an effective annual rate of 11.67%.

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