What is your investment rate of return? This is a question that investors often struggle to answer. It is not as simple as taking the difference between the current value of your portfolio and the starting value. There are other important considerations to factor in, such as inflow and outflow of capital, length of investments and dividends. The complexity of calculating your returns is perhaps the main reason why most investors do not even attempt to do so. However, knowing your rate of return is actually essential part of managing your own portfolio. It can tell you if you are…
What is your investment rate of return?
This is a question that investors often struggle to answer. It is not as simple as taking the difference between the current value of your portfolio and the starting value. There are other important considerations to factor in, such as inflow and outflow of capital, length of investments and dividends.
The complexity of calculating your returns is perhaps the main reason why most investors do not even attempt to do so. However, knowing your rate of return is actually essential part of managing your own portfolio. It can tell you if you are beating the market and whether your investments strategies have worked so far. For instance, if your returns are consistently below the market performance, you may wish to invest in index exchange-traded funds (ETFs) instead. Whereas, if you are constantly outperforming the market, then shifting more money into stocks may boost your long-term performance even further.
Because of that, I thought it would be a good idea to discuss two useful methods to calculate your rate of return. This is article is divided into two parts. The first looks at money-weighted rate of return and the second will discuss cash-weighted rate of return.
Money-Weighted Rate of Return
The money-weighted rate of return (MWRR) is a measure of your investment returns that takes into account the size and timing of cash flows. As such, it is considered an accurate reflection of the nominal investment return of a portfolio.
To calculate the MWRR, we first identify the inflows and outflows of cash in the portfolio. Theoretically, the present value of cash inflow should be equivalent to the present value of cash outflow. By balancing that equation, we can obtain the rate of return.
The equation looks like this:
Present value of inflow = Present value of outflow
Let’s take this simple example. John buys a share for $1,000 and collects $20 dividends each year for two years. After which, he sells it for $1,250.
The cash inflow refers to the starting value of the investment, dividends reinvested and withdrawals made. In the scenario above, John did not reinvest his dividend or withdraw cash before selling the share. The present value of inflow is therefore $1,000.
The cash outflows in this case refer to dividends received and amount received from the sale of the stock.
We can calculate cash outflow using the following equation (R for this equation is the rate of return):
Present value of outflow = (dividends received in first year)/(1+R)^year received + (dividends received in second year)/(1+R)^year received + (amount received from sale of shares)/(1+R)^year sold
Present value of outflow = $20/(1+R) + $20/(1+R)^2 + $1250/(1+R)^2 = $1000
By solving for R, we can calculate the money-weighted rate of return. For this case, the MWRR is 13.7%.
A simpler way of calculating
You might probably think that this is definitely not worth the effort. Even for a simple portfolio like the one above, we have to put so much effort into calculating the return, let alone a more complicated one like our own.
Thankfully, Excel and Google Sheets have created a function that simplifies the process for us. All we need to do is input all inflows and outflows to our portfolio at the correct time intervals and by using the formula, we can easily calculate our MWRR. There are even online financial calculators that can do the work for you.
Shortfalls of using MWRR
As the name suggests, MWRR puts emphasis on the amount of money a portfolio has. It may be an accurate reflection of the investor’s returns but may not accurately depict the skill of the investor.
If an investor adds a large sum of money into the portfolio just as the stock appreciates in value, then the MWRR will be skewed. The larger portfolio benefits more in dollar terms from the growth.
The Foolish bottom line
Learning to calculate your investment returns is an extremely useful skill. The money-weighted rate of returns will tell us how well our portfolio has performed, and whether our investment strategy has worked so far. In the next article, I will take a look at the time-weighted rate of return, which is another useful method of calculating our portfolio returns.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Jeremy Chia doesn’t own shares in any companies mentioned.