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The final step in the portfolio design process is to measure and monitor your portfolio’s actual annual rate of return. This involves the following two distinct activities, as outlined in detail below:

  • measuring your portfolio’s actual annual rate of return, and
  • monitoring the actual annual rate of return in relation to a specific yard stick or benchmark

Both activities are important in determining the success or failure of your investing activities. Without this step, how do you know if your investing efforts are helping or hurting your saving efforts? How do you know if your saving efforts are helping you to accumulate $2.00, but your investing efforts are costing you a dollar or adding a dollar? Let’s look at these activities closer in the following sections.

Measuring your portfolio’s actual annual rate of return

There are a number of methods that can be used to calculate your portfolio’s actual rate of return, some are simple including asking yourself the question, "What is my bottom-line?"  Other methods, however, are more complicated involving monitoring the performance numbers published by financial institutions.

Most investors simply rely upon the bottom-line method for assessing their investment portfolio’s success or failure. The bottom-line method simply consists of opening the monthly statement and looking at the bottom-line number. If that number is higher than the previous month’s then the measurement is complete – success! If it’s below the previous month’s bottom-line number, the investor shrugs and thinks, "Oh well, maybe next month will be better!"

Some investors rely on the performance numbers and commentary published by the investment’s manager. They look at the numbers, read the commentary and correctly or incorrectly assume these are an accurate reflection of their own investment's performance.

Very few investors actually track and measure the actual annual rate of return for their investment portfolio. Either they are not interested, believe they lack the tools to properly measure their performance, or simply do not care enough to make the effort. However, measuring your portfolio’s actual rate of return need not be difficult or time consuming if you establish simple routine and guidelines.

Below is an outline for a simple routine for measuring your portfolio’s actual annual rate of return. Most of the information you require for the calculation is already supplied for you in your account statements.

Note: This simplified method for calculating the actual rate of return for a given period does not calculate the time-value rate of return for the contributions made during the measurement period. It assumes that all contributions are made at the beginning of the measurement period. The impact on the calculation should be minimal and does not detract from the purpose for the calculation, which is to provide a means of assessing your portfolio’s actual rate of return. In addition, your calculations may or may not include your investment’s accrued income. This will depend upon how the market value of your investments is determined for each statement period. As long as the calculation of the statement values remain consistent, the steps outlined below will calculate an accurate estimate of your portfolio’s rate of return.

Example:  The Smith family would like to calculate the actual rate of return earned by their investment portfolio. When they look at the prior year’s December 31 account statement, the market value of their investment portfolio was $100,000.00. According to the most recent December 31 account statement their investment portfolio had a market value of $113,000.00. Also on the most recent December 31 statement, their account received $3,200.00 in Dividends and $3,000.00 in Interest Income during the preceding 12 months. In addition, the Smiths contributed $500.00 per month or $6,000.00 during the same 12-month period. This would mean that the Smith’s actual annual rate of return ($13,000 less $6,000 = $7,000) was approximately $7.00% ($7,000 divided by $100,000).

Remember: By calculating your rate of return using the information from your account statements the rate of return will be what your investments earned after deducting all investment costs and fees.

So now we must try to answer the next most important question: Is a 7.00% actual rate of return good or bad?

Monitoring the actual annual rate of return in relation to a specific yard stick or benchmark

When the investment industry became more sophisticated in its understanding of investment returns and their relationship to an investment’s volatility or risk, they quickly adopted a qualifying approach to measuring an investment’s rate of return. No longer was it acceptable to simply state one’s actual rate of return (for example 7.0%), but you now had to qualify the rate of return in relation to the amount of risk you assumed to achieve the rate of return.

So did you earn a 7.0% rate of return by investing 100% in Guaranteed Investment Certificates (GICs) or were you investing 100% in Emerging Market Mutual Funds? Your rate of return was now judged by how much risk you took on to earn it. As a result benchmarks were born. A benchmark is a form of ruler or yardstick that is meant to help explain an investment’s rate of return in relation to the risk level of the investment.

Example:  If your portfolio was only going to be invested in a diversified portfolio of Canadian stocks then may be you would use the S&P/TSX 60 Index or the S&P/TSX Composite Index as your benchmark against which to assess your portfolio’s rate of return.

Note:  Benchmarks exist for almost all asset allocations, investment styles, approaches and category.

So, if your portfolio contained investments similar to those found in the S&P/TSX 60 Index and the Index earned a 10.0% rate of return, then your 7.0% rate of return would be said to have under-performed your benchmark. Conversely, if the index had earned 4.0%, then your portfolio’s 7.0% rate of return was superior when compared with your benchmark.

Note:  Benchmarking your portfolio’s annual rates of return can be a double-edged sword. How? Well, let’s say that your actual rate of return was negative 7.0% and the S&P/TSX 60 Index had a negative 10.0% rate of return. Well, you should be celebrating since your investments outperformed. Your portfolio only lost 7.0% of your hard earned savings, when it could have been worse. You could have lost 10.0% like your benchmark did.  And if you are a professional money manager, you will probably get your bonus because you outperformed your benchmark by only losing 7.0%! For the Smiths in our example above, however, a 7.0% investment loss would mean the loss of their hard-earned savings contributions and $1,000 of their investment income. An investment loss like that is hardly something to celebrate.

Personalized approach to benchmarking

Our preferred approach to monitoring an investment portfolio’s success or failure is for you to construct your own benchmark.  If you have established your own financial goals based upon your Financial Starting Point, your ability to save, and your investing personality, then it seems to make sense that your benchmark should be customized to you.

In fact by following the 12-step process for designing an investment portfolio you will have already created a personalized benchmark in Step 5 – Calculate your Required Average Annual Rate of Return. Your required average annual rate of return is your investment portfolio’s personalized benchmark.

Example:  If you have calculated that your investment portfolio must earn 6%, on average, each year then this is what your portfolio should be designed and managed to achieve. If you have earned 7% and the stock market was up 10%, should you care? Should you feel disappointed? No! You are on track to achieving your financial goal.

Remember:  Your investment portfolio’s goal is not to match or outperform some benchmark you do not control or manage. Your investment portfolio’s goal is to safeguard your savings and to earn a rate of return that helps you to reach your financial goal. Manage your investments toward a benchmark that is within your control. By using your required average annual rate of return as your portfolio’s benchmark, you can now assess your investing success or failure in working toward your goal.

Example: If you are starting with $100,000 in your portfolio and your required average annual rate of return is 6%, you can gauge each year if your investments are succeeding or not. Knowing this, you also know that after 3 years, your portfolio must have an accumulated market value of $119,101.60 if you are to achieve your financial goal. If after three years your portfolio is only worth $110,000.00 or less, then you know that your investments are under-performing and changes may be required if you are to achieve your goal.  You cannot afford to keep following the same investment process. Following a losing investment path hoping things will turn around is not an investment plan that results in success.  On the other hand, if after three years your portfolio is worth $126,000.00, then you know you are on track to reach your financial goal. No changes to your investment approach are necessary. If in fact your required rate of return projected that you were to have $119,101.60 and you have accumulated $126,000.00, you should consider re-balancing by selling the $6,898.40 ($126,000 - $119,101.60) in excess profit and reinvesting it in the safety of Fixed Income investments.

Remember:  Monitoring and comparing your investment rate of return to your own personal benchmark is of greater value in your efforts to achieve your financial goals.

Members’ Note:  InvestingForMe provides its members with a Projected Annual Portfolio Value Comparison calculator that compiles your age, your Financial Starting Point, your savings contributions, and your required average annual rate of return to create a customized benchmark schedule. This calculator is found with other spreadsheets and planning tools in the section Financial Planning and Budgeting: InvestingForMe Tools. This schedule can also be saved conveniently to a member’s My Folder section for future reference and updating as your circumstances change.

 

 

 

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