“It’s not how much money you make, but how much money you keep,
how hard it works for you, and how many
generations you keep it for.”

—Robert Kiyosaki – Founder of the Rich Dad Company

We all want to know how we are doing with our investment portfolios. The question is, how do we judge that, and are we looking at the wrong information?

Calculating your return on investment (ROI) seems simple. You simply take the gain of your investment, subtract the cost or expense of the investment and divide the total by the cost of the investment: ROI = (Gains – Cost)/Cost.

For example, if you buy 20 shares of stock for $10 a share, your investment cost is $200. If you sell those shares for $250, then your ROI is ($250–200)/$200, for 25 percent..

But financial advisors, and some sales organizations,  use other methods to calculate ROI, depending on a client’s situation and what they are trying to sell!  They can be confusing!  Here is an overview of just these three methods and some other things to consider.

Ways to Calculate Your Return

When judging the return on an investment, or an entire portfolio, we need to understand how the return is calculated. There are many ways to calculate return, including time weighted, dollar weighted and simple average. Just looking at the percentage might not tell the entire story.

1. Time-weighted return  – This methodology is sometimes called “reported return,” “portfolio return,” “investment return” and “geometric mean return.” It does not account for any cash inflows or outflows. Calculating your return using this method assumes that you don’t make any transactions at all. It’s like asking how much $100 invested on January 1st is worth today.  This method tracks the performance of your investments only. This makes it easy to compare your return to a benchmark, such as the S&P 500 Index, but may not reflect how you did if you added to withdrew funds.

2. Dollar-weighted return  – This methodology is sometimes called “money-weighted return,” “personal rate of return” and “internal rate of return,” or IRR. It does account the timing and size of any cash inflows or outflows into or out of your portfolio. This calculation might seem more accurate because it takes your personal investment activities into consideration, but it’s harder to compare against a benchmark.

3. Simple-average return –This methodology uses an average of two or more annual returns to calculate your overall return. For example, if you had a 20 percent return one year and then the investment went down 20 percent the next year, your average return is zero percent (20% – 20% = 0). However, the dollar value of your portfolio has actually gone down. Had you invested $100,000 and made 20 percent, the value of your investment would be $120,000. And then if the value dropped 20 percent, you would lose $24,000, and the value is now $96,000. So you are down 4 percent, despite the average return of zero percent.

Expense Can Be Misleading

One metric that can be misleading when calculating your return is expense. It’s certainly a consideration, but the most important factor is the net return. If one investment has an expense of 1 percent and a return of 4 percent, and another investment has an expense of 3 percent and a return of 10 percent, then the latter is better. Wouldn’t you rather earn 10 percent than 4 percent?

It is also important to understand all components of expense — both internal and external. This is something an experienced and trusted financial advisor can assist you with.

Don’t Forget Income Tax

Yet another consideration is the impact of income tax. A tax-exempt return of 4 percent could provide a better net return to you than a taxable investment that earns 7 percent, depending on which tax bracket you’re in. At the end of the day, it’s not how much you make; it’s what you keep that’s important. Understanding the potential tax implications of an investment and selecting investments that make sense for your personal situation are critical to making decisions that can maximize your net return.

When comparing one portfolio or investment to another, we believe you need to understand the return you are looking at and understand what you will net after fees, expenses and taxes. There are myriad factors to consider when evaluating investments and your portfolio.

The most important thing to consider, in our opinion, is whether or not the portfolio meets your needs, objectives and risk tolerance. We believe that the true value of a trusted and experienced advisor is not in selecting investments but in helping you achieve the highest potential net return that meets your needs and objectives in a manner consistent with your risk tolerance. In this way, a good advisor may more than makes up for the cost of his or her services.

Please feel free to contact us, without cost or obligation, to discuss your personal vision and how we can help you achieve it.  We are happy to provide a second opinion on any investments or portfolios.   Randy.carver@raymondjames.com or (440) 974-0808.

The information contained in this blog does not purport to be a complete description of the securities, markets, tax rules or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Randy Carver and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk, and you might incur a profit or loss, regardless of strategy selected.  These calculators are hypothetical examples used for illustrative purposes and do not represent the performance of any specific investment or product. Rates of return will vary over time, particularly for long-term investments. Investments offering the potential for higher rates of return also involve a higher degree of risk of loss. Actual results will vary.