The best way to know how a portfolio is performing is to calculate the return on a regular basis. While this exercise may seem easy, the math can get tricky. Mistakes are common and sometimes they compound into very large errors. I find there are two common mistakes people make when computing return of investment calculation. Both errors are explained below.
Counting Deposit and Withdrawal as Investment Gains and Losses
A common error when doing return of investment calculation is to treat deposits as investment gains, and withdrawals as investment losses, rather than treating them as additions or subtractions to an account. Here is one embarrassing real life example of a group that counted deposits as investment gain:
The Beardstown Ladies are members of a famous investment club formed in the early 1980s. The ladies rose to prominence in the mid-1990s after the club proclaimed fantastic investment results. For 10-years ending 1993, the club reported a compounded return of 23.4% in their stock portfolio versus 14.9% for the S&P 500. The ladies bought stocks of companies they knew, like McDonald’s and Coke. The investment success propelled the ladies into stardom. They appeared on TV shows and in commercials, spoke on radio programs, and not to miss a moneymaking opportunity, published best selling books on the subject of personal finance and investing.
The world changed for the Beardstown ladies in late 1997. A reporter from the Chicago magazine noticed something peculiar about their published investment results. After calculating the numbers several times, he concluded that a gross error had been made. The error was so large, that the accounting firm of Price Waterhouse was called in to clear the air. In the final tally, the clubs worst fears were realized. The ladies’ actual return was only 9.1%, far below the 23.4% they reported, and well below the S&P 500. For years the ladies deposited monthly dues into their account and classified it as an investment gain, rather than additional capital. An embarrassed treasurer blamed the error on her misunderstanding of the computer software the club was using.
It is natural to make return calculation errors in a bull market. Investors expect their account to be performing well. An error may not be large enough to effect performance in the short run, but if not corrected, the distortion compounds over time. Deposit and withdrawal are never treated as investment gains and losses with one exception, withdrawals used to pay direct investment expenses such as manager fees and trading costs are treated as a loss.
Buying and Selling Can Cause Return of Investment Calculation Errors
Flip through the mutual fund section of your local newspaper and you can quickly tell how your funds are performing. Although the return of a fund is listed correctly in the paper, it may not tell you much about the performance you have personally experienced in the fund. Return of investment can become distorted if you make frequent transactions in your account, such as adding money to a 401(k) plan each month. The following example highlights this problem:
At the beginning of the year, you invest $1000 in a stock mutual fund. By the end of the year that mutual fund is up 15%, therefore, you made a $150 profit. Satisfied with this result, at the start of the second year you place another $1000 in the mutual fund bringing the total to $2150. Unfortunately, during the second year the market moves down and the fund falls 10%. Overall, your account lost $215, leaving you with a balance of $1935.
Here is an interesting question. During the two-year period, what was the return of the mutual funds and what was your actual return?
The mutual fund gained 15% the first year and lost 10% the second. A $100 investment grew to $115 after the first year and fell to $103.50 after the second. That’s a total gain of 3.5% for the period and an annualized return of 1.7%. Although the fund had a positive return, you did not make any money. You lost $65. Your annualized return was -2.2% based on average two-year investment of $1575 ($1000 the first year and $2150 the second). In affect, the return of the mutual funds was not the same as your return.
The return of investment to the investor is not determined by the performance of the markets, it is determined by the behavior of the investor. In the example above, the fund did not cause the $65 loss, a timing error by the investor caused the loss. Let’s look at this phenomenon in a larger picture. The stock market returned about 18% annually over the last 20 years, however, the average investor did not experience returns close to that number in their personal portfolios. The average stock investor earned significantly less than the stock market. The timing of cash flows into and out of various investments was a large cause for the difference.
