I just read another article about returns. I don’t understand why everyone out there is constantly summarizing different ways to calculate returns when there is only one way that matters to you as an investor. While it is important to understand how other returns are calculated the average investor really only cares about their own returns.
To summarize, there are basically 3 ways to calculate returns:
- Regular rates of return - this should be used for quick summaries usually. It is computed as (End Value – Total Contributions) / Total Contributions. Can be annualized to calculate actual returns if no additional contribution is made after the initial contribution.
- Time Weighted Returns - Used by mutual fund companies to remove the effects of individual investors moving their money in and out. Calculates the ‘pure’ performance benefit that advisors bring.
- Dollar Weighted Returns (you should use this one!) - Internal rate of return (IRR) calculates returns taking out the effect of when contributions were made.
This info sheet (pdf) has the clearest explanation I have found of how these calculations can provide very different results. And it doesn’t require wading through overwhelming math like most explanations.
Because IRR is the only way to take out the effect of when funds arrive in the account, it is the preferred way to calculate your individual returns. This is especially true for those of us who use dollar cost average. Since the only way to compute the IRR is to track when you put the money in, you will need a spreadsheet to help you and you will need to input numbers often. I’m not too concerned about getting the returns down to the day so I use my quarterly statements to calculate how much I contributed for the quarter and annualize that value (note in Excel you need to calculate -IRR not IRR or you will be getting the negative of your return).
Since I’m tracking my returns quarterly, I also use it to tell me how much my portfolio should be worth if I were getting the return I want on my portfolio (you just do compounding on the contribution and add them up) this way I can see in one shot if I’m meeting my expected return or not and if not, how far am I off. I use this to adjust how much I need to top up my contribution to my investments.
In the end it is the final dollar figure that I really care about. All of the talk about math is inconsequential.
Comment if anyone is really interested in how the excel spreadsheet works.