Wednesday, 13th January 2010

How to measure investment performance

Written by George Traganidas Topics: Stock Investing

As investors, it is very important to keep track of our yearly returns. Returns should be compared with a benchmark and our job is to beat the benchmark. If you can not beat the benchmark then it is better to buy it. This will save us money and time in the long run. There are certain things to consider when you measure performance:

First of all we must know what we measure. For example, assume we have a trading account of £10,000 and we decide to buy 1000 shares of Company X for £5.00 per share. Once we buy the shares, we will have in our account £5,000 in cash and 1000 shares of company X worth 5,000. Now assume that by the end of the year the shares increased in value and they are worth £6.00 per share. We can calculate our return in 2 ways:

A) Initial cost of shares is £5,000 and current value is £6,000, for a gain of £1,000 that is a 20% return (1000/5000) in 1 year.

B) Initial account value (cash + shares) is £10,000 and current value is £11,000. This is a gain of £1,000 for a return of 10% (1000/10000) in 1 year.

As you see from above, the two methods give different results. A lot of people focus on the 1st method to report their returns and ignore the impact of cash sitting idle in their account. That is not correct.

When we measure our returns we must define what constitutes our investment fund and then measure it all, even cash that is idle.

2) Factor in cash deposits and withdrawals

A lot of people do not exclude from the measurement of performance the impact that cash deposits and withdrawals have. For example, if we have a bank account with £10,000 that returns 3% per annum then at the end of the year you will have £10,300 for a return of 3%. If we put more money in the account in the middle of the year, our yearly returns will be more than 3%. Does this mean that we are a better investor? No. We just deposited more money in the account and this has changed our performance result.

When we calculate performance we need to remove the influence of cash deposits and withdrawals, because they affect the returns. The way to do this is by using “Time Weighted Rate of Return” to measure performance.

Time Weighted Rate of Return

Assume that we have an account with £10,000 in cash and that we buy 1000 stocks of company X at £3.00. After 3 months we add another £2,000 in the account. At the end of the year, the stock price is £3.50. At our account we have £9,000 in cash and stocks that are worth £3,500 for a total of £12,500. What is our return?

In order to calculate this, we need to measure the performance of the stocks and exclude the influence of the cash deposit. We start by getting the value of the account at the start (T0).

Value at T0 = £10,000

Next step is to calculate the value of the account just before we input the new money (T3m). Let’s assume that at T3m the stock price is £3.10.

Value at T3m = 7000 + 1000*3.1 = £10,100

Then we deposit the £2,000 in the account and the value has increased to £12,100. Now we need to calculate the value at the end of the year (T12m).

Value at T12m = £12,500

To calculate the total return, we need to calculate the individual returns of the two periods (before we deposited the cash and after) and combine them. To do this, we divide the money at the end of the period by the money at the start of the period for each one of the periods and then we multiply them.

Total return = [(10100/10000) * (12500/12100) – 1] * 100%
= [1.01 * 1.03 – 1] * 100%
= 0.0403 * 100%
= 4.03%

As we can see from the calculation above we have excluded the cash deposit and thus it is a true reflection of performance.

This way of calculating performance is more complicated that simply dividing the end account value with the starting one, but it is more accurate. I think that it is worth the extra effort so we know how well we are doing and can compare our performance to an index. Have fun beating the index.