Now that I’ve purchased my condo, I’ve been able to catch up on my retirement contributions. Last month I fully invested in my solo 401k and this month I fully contributed to my Roth IRA. My investment assets are getting large enough where I can begin to use asset allocation without worrying about meeting index fund minimums. While doing some research about investing and asset allocation, I stumbled upon the correct way to calculate my investment return, which is important for comparing your portfolio to appropriate bench marks.
The Beardstown Ladies were a famous investing club that claimed to have compounded returns nearly 10% higher than the S&P 500. After a few years of receiving national acclaim, it was discovered that they were including account deposits as investment gains. After adjusting for these account deposits, the Beardstown Ladies’ return was actually 6% below the S&P 500. Most people won’t be embarrassed nationally by not knowing how to calculate your investment return, but it is essential for managing your own portfolio.
Time-Weighted Return (TWR)
TWR is the industry standard for calculating your investment return. A TWR measures your performance over a specific period of time. There are three simple steps for being able to correctly calculate your TWR. If there are no contributions or withdrawals you simply subtract your final balance from your initial balance, divide by your initial balance and multiply by 100.
(Fina l- Initial)/(Initial)*100 = TWR
Contributions and Withdrawals
The simple calculation above gets slightly more complicated when you have to account for contributions and withdrawals. To calculate the TWR with contributions and withdrawals, you divide your final balance less half of your contributions plus half of your withdrawals with your initial balance plus half of your contributions less half of your withdrawals. Subtracting 1 from that calculation nets you your TWR for that time period.
[(Final - 0.5*C + 0.5*W)/(Initial + 0.5*C - 0.5*W) - 1 ] = TWR
Stringing Together Time Periods
The idea behind the TWR is to calculate smaller time periods like monthly or quarterly and then string them together to get larger time periods like yearly. This final step is pretty simple. Consider the example where you have 4 quarterly returns and are calculating the yearly return. Add 1 to your quarterly returns, multiply these values together, and subtract 1 from this final value.
It is very important to be able to correctly calculate your investment returns. If you can’t calculate your investment returns, you may think you’re beating the market when you’re severely under performing the market. Asset allocation is all about understanding the risk and return trade off. It’s important to know that you’re getting the returns needed to justify the risk that you’re taking. Don’t be like the Beardstown Ladies!
Happy Easter everybody
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