Q: I’ve been investing for a few years now and I find it challenging to really understand how my investments have actually performed. And the statements I get from my advisor are a bit confusing. How can I calculate my actual investment returns?
A: Tracking the performance of your investments is not as difficult as you might assume. Once you understand a few simple formulas, you can use a calculator or spreadsheet software to determine common metrics, such as annual rate of return or after-tax return.
Determining rate of return
Probably the most basic calculation for investors is return on investment. Total return includes capital appreciation and income components, and assumes all income distributions are reinvested. If you automatically reinvest distributions such as interest or dividends, but added no other new funds to the account, total return is calculated by taking the difference in an investment portfolio’s ending and beginning balance, and dividing that difference by the beginning balance. In formula format, it would look like this:
(Calculator or Spreadsheet:)
(Ending Balance [EB] – Beginning Balance [BB])
For example, Joe started with an investment of $10,000. After five years, his portfolio’s value increased to $12,000. He can determine his portfolio’s total return as follows: ($12,000 – $10,000)/$10,000 = 0.20, or 20 percent. Therefore, Joe can say his $10,000 has increased by 20 percent.
To annualize this total return, you’ll need to calculate the compound annual return.
For example, Jane also originally invested $10,000. However, it took her portfolio only two years to grow to $12,000. If you measure the performances of both Joe’s and Jane’s portfolios by using the formula above, both increased by 20 percent. To take the difference in time into consideration — i.e., to calculate the compound annualized rate of return — you would need a calculator that can raise to powers. Here’s what the formula would look like:
Compound Annualized Rate of Return:
Calculator: [(EB/BB) ^ (1/# of years) – 1]
[(EB/BB) ^ (1/# of years)] – 1
Using this formula to calculate Joe’s annual compound return, we take $12,000/$10,000 = 1.2. Then, we raise 1.2 to the 1/5 (or 0.20) power, giving us 1.03714. Subtract out 1, and we have 0.03714, or 3.714 percent, which is Joe’s annualized return. Jane’s portfolio, on the other hand, performed much better, earning 9.54 percent on average every year. Of course, two different investments should not be judged solely on performance results for short periods of time or for different time periods. The risk of the portfolio must also be considered.
The Rule of 72
If you need to estimate how your nest egg might grow, you might want to use the Rule of 72. This can reveal how long it could take your money to double at a particular rate of return. To calculate this measurement, you would use the following formula:
72/Annual Rate of Return = Number of years it will take for your money to double at a particular rate of return
For example, Jane and Joe want to figure out how long it will take their $10,000 investments to double to $20,000. They would use their compound annual rates of return (as explained above) to estimate how many years it will take to double their money. Joe estimates it will take over 19 years (72/3.71 percent = 19.4 years). However, Jane’s portfolio could grow to $20,000 in less than eight years (72/9.54 percent = 7.55 years).
It is important to note that the Rule of 72 does not guarantee investment results or function as a predictor of how your investment will perform. It is simply an approximation of the impact a targeted rate of return would have. Investments are subject to fluctuating returns, and there can never be a guarantee that any investment will double in value.
Remember taxes and inflation
You should always take into consideration the effects of taxes and inflation when constructing an investment plan to meet your financial objectives. After all, even though Jane earned an average 9.54 percent on her investments every year, her “real” rate of return will be reduced by taxes and increases in the cost of living.
Depending on Jane’s situation and income-tax bracket, as much as 39.6 percent of her 9.54-percent compound annual return could be paid in federal taxes, leaving her with [9.54 percent x (1 – 0.39.6)], or 5.76 percent.
Then, Jane must figure in the effects of inflation on her earnings. For example, assume inflation averaged 3 percent over the two years that Jane invested her $10,000, and that she earned a 5.76-percent compound annual return after taxes, but before inflation. Now, Jane must adjust her after-tax return for the loss of purchasing power caused by inflation. To determine an inflation-adjusted rate of return, use the following formula:
(Calculator or Spreadsheet:)
[(1 + Rate of Return) / (1 + Inflation Rate) – 1] x 100
Jane’s inflation-adjusted, after-tax rate of return is [(1.0576)/(1.03) – 1] x 100, or 2.68 percent. Keep in mind that we’ve assumed the highest federal income-tax bracket (which does not apply to every investor); however, the example does show the impact that taxes and inflation can have on your return.
No substitute for understanding
No matter what your level of investment experience or sophistication, you may benefit from developing a relationship with a financial advisor. Why? For starters, a qualified financial professional can help you understand your investments’ performance, so you don’t have to do these calculations yourself. While it is still your responsibility to know what it all means, a trusted financial professional can make sure you grasp what the numbers are revealing.
From a “big picture” perspective, a financial pro is also trained to analyze your personal financial situation and prepare a program designed to help you address your financial goals and objectives.
Jeremy R. Gussick is a CERTIFIED FINANCIAL PLANNER™ professional affiliated with LPL Financial, the nation’s largest independent broker-dealer.* Jeremy specializes in the financial planning needs of the LGBT community and was recently named a 2015 FIVE STAR Wealth Manager as mentioned in Philadelphia Magazine.** He is active with several LGBT organizations in the Philadelphia region, including the Delaware Valley Legacy Fund and the Independence Business Alliance, the Philadelphia Region’s LGBT Chamber of Commerce. OutMoney appears monthly. If you have a question for Jeremy, you can contact him via email at [email protected] Securities and Advisory Services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC.
*As reported by Financial Planning magazine, 1996-2015, based on total revenues.
**Award based on 10 objective criteria associated with providing quality services to clients such as credentials, experience, and assets under management among other factors. Wealth managers do not pay a fee to be considered or placed on the final list of Five Star Wealth Managers.
Information and calculators are made available to you as self-help tools for your independent use and are not intended to provide investment advice. We cannot and do not guarantee their applicability or accuracy in regards to your individual circumstances. All examples are hypothetical and are for illustrative purposes. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
This article was prepared with the assistance of Wealth Management Systems Inc. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you discuss your specific situation with a qualified tax or legal advisor. Please consult me if you have any questions.
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