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BULLS & BEARS: Use paper, fifth-grade math to track investment results

July 17, 2006

Throughout history, we have devised methods to calculate and measure results for all kinds of activities. In academics, we have grading systems that measure student performance. In sports, the most important factor in any game is the score.

But when it comes to keeping track of investment results, I suspect that many investors do not have a good grasp on how well their money has performed.

Attempting to keep a mental scorecard of the rate of return on your investments can become cloudy, since over time most investors make irregular contributions or withdrawals to and from their portfolios. Therefore, it is wise to use a mathematical formula to calculate your historical returns.

Most brokerage statements do not provide performance results that are calculated in any useful way. This is puzzling, since these firms surely have the technology and all the data necessary to calculate client returns.

Granted, the rate of return on your investments measures only the past and says nothing about future results. But a review of your investment scorecard over a period of time, say three years or more, can provide the basis to determine if you are on the right track with your investment strategy.

One danger in this exercise is that an investor can become too obsessed about short-term results. Over any short period, an investor's return may be out of sync with the aggregate market results. It is financially unhealthy to feel compelled to act on every zig or zag in your portfolio. As long as an equity investor is comfortable with his overall long-term strategy, lagging the stock market in the short term should not cause alarm.

On the other hand, not paying any attention to investment performance over the long haul can be just as detrimental. I'm always amazed to see large sums of money parked in a habitually underperforming mutual fund.

So do periodic checks of your progress. For example, the first half of 2006 has just been completed and it might be a good time to take a peek at your returns. For the six months through June 30, the S&P 500 index has returned 2.7 percent, and a risk-free return would have produced about 2 percent. For the three-year period beginning June 30, 2003, the S&P 500 has returned 11.2 percent annually.

Perhaps your six-month return is not up to snuff with the market-in most cases, this should not be troubling. However, if your three-year return reveals a significant underperformance from the aggregate market, you might start to ask some questions.

So where does one begin to calculate a rate of return on your portfolio? You might think it is as simple as taking the change in value of your portfolio over a given period and dividing by beginning value. But if you have made contributions and withdrawals to your investment accounts, the size and timing of those cash flows need to be taken into consideration.

Thus, arriving at an accurate rate of return can appear complex. For instance, the CFA Institute has a 150-page book that provides guidelines to investment firms on how performance results should be compiled and presented to the public.

Fortunately, a pencil and paper and some fifth-grade math will do the trick. A Google search for a formula called the Modified Dietz Method will provide the necessary means for most investors to calculate reasonably accurte investment returns on their portfolio.



Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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