By Wealth Foundations

Investment returns are often not what they seem

There is often a lot of misguided talk, sometimes boasting, about the level of returns people get on their investments. This can leave some feeling as though they’ve missed out.

Before you get too caught up in what others are (apparently) achieving you need a good understanding of some important investment return concepts. You need to make sure you are comparing apples with apples and this is often very difficult to do.

We look at three fundamental issues that need to be considered when reviewing investment returns.

First, investment returns need to be calculated correctly

Some returns are quoted for an entire time period, while others are quoted on a per period basis.

Joe says he has achieved a 36% return on his investment. Sounds impressive, yet not so impressive when you find out that he invested $10,000 a month ago and it’s now grown by 3% to $10,300.

Returns are mostly quoted on an annualised basis for periods of a year or greater. However, for periods of less than a year returns are quoted on an absolute basis with reference to the period (e.g. 3% for one month). Joe has taken his one month return and multiplied it by 12 to give himself a “notional” annual return of 36% .

Mary says her investments doubled over the past 5 years. By her reckoning, she got a return of 20% p.a. which she claims is much better than the market’s return of 17% p.a. However, she has calculated her return using a simple (or arithmetic) return calculation (i.e. 100% ÷ 5).

The market rate of return (along with the majority of investment returns) is calculated using a compound (or geometric) return. In Mary’s case, the compound return of her investment is (1 + 100%)? – 1, where n = 1 divided by the number of periods (=5). Mary’s compound return was only 14.9% p.a. – well below the market’s return of 17% p.a.

Dominic has had a volatile ride with his investment. Since initially investing his $10,000 , he has kept track of his annual returns. The investment jumped by 50% in the first year, then fell by 40% the next year and then rose by 8% in the third year. He believes his return is 6% p.a. (i.e. +50% – 40% + 8% = 18% ÷ 3 years = 6% p.a.)

However, Dominic has also fallen into the trap of using the simple return methodology. The table below shows the path of his investment:

It reveals that Dominic is deluding himself about earning a 6% p.a. return. His compound return is actually negative at -0.9% p.a.

Second, your investment return must be compared with a benchmark

Reviewing any investment return without reference to a relevant benchmark is a little meaningless. The most important benchmark to use is one that is risk based.

Ted earned a return of 9% for the year and Max earned 8%. Ted appears to have had a better year.

However, Ted has a geared portfolio exposure and Max has a balanced portfolio. The relevant benchmark for Ted’s portfolio earned 12% for the year (derived by applying market rates of return to the same risk exposure). Max’s benchmark portfolio earned 7% for the year.

Ted significantly under performed on a risk-adjusted basis, while Max out performed. On this basis, Max had a better year.

Third, cash inflows and outflows “muddy the waters”

As soon as you start to include investors’ contributions to and withdrawals from their portfolios, returns become personalised.

Consider Greg and Sue. Each start the year with a portfolio of $200,000 and end the year with a portfolio valued at $220,000. On the face of it, the compound return for each is 10%.

However, Sue withdrew $100,000 at the end of the first month and re-contributed it at the beginning of the last month. Is her return really the same as Greg’s?

Greg had all his capital invested throughout the year. For 10 months of the year, Sue had only $100,000 of her capital invested, yet ended up with the same portfolio value.

To calculate Sue’s return we have to use what is known as a “Money Weighted Rate of Return” calculation. This takes into account the amount invested and any contributions to and withdrawals from the portfolio. Measured correctly, Sue’s return on her capital was 17% for the period.

Every investor interacts with their portfolio differently. While the Money Weighted Return is the most accurate measure of your return on capital, it is also the most personalised. It makes it almost impossible to compare one investor’s return with another’s in any meaningful way.

Historical investment returns have limited use

A review of your historical investment performance is important to assess whether you achieved an appropriate return for the level of risk taken.

Its important to compare your portfolio’s return relative to a benchmark portfolio that holds the same asset class exposure and uses market rates of return. While this ignores the impact of cash inflows and outflows, the aim is to provide a meaningful return to be able to evaluate the ongoing relative performance of your portfolio’s investment strategy.

While the purpose of this article is to show that the measurement and assessment of historical return is not straightforward, we don’t advocate that you get too caught up on this subject. After all, good investment planning is about making future based decisions. And your historical returns may have little relevance to those decisions.

Wealth Foundations (ABN 36 121 535 993) is a licensed Australian financial services firm (AFS Licence No. 317369). The material contained in this article is for general purposes only and should not be used as a substitute for personal financial advice. This article does not take into account your specific objectives, financial situation or needs. No person should act or refrain from acting solely on the basis of this material. Before making a financial planning or investment decision, you should consider if it is appropriate for your circumstances. You should read and understand any relevant Product Disclosure Statements or any other associated documentation relevant to your individual situation.