Do most investors know how their investments are faring? Probably not. According to an article in Money magazine, many investors (as many as 80% of those studied) don’t have a clue how their investments have performed relative to “benchmark” indicators such as the Standard and Poor’s 500 stock index. Several studies were cited that described how investors tend to exaggerate their returns. For example, more than a third of investors who claimed to “beat the market” actually lagged it by 5% or more.
The author of the article speculated that one reason for investors’ overestimation of their return is “human nature.” People like to believe that they are better than average and brag about how their “superior” investments outperformed all others. Another explanation is that many investors don’t know how to calculate the annual return on their individual portfolio or are unaware of the performance of appropriate market benchmarks (e.g., stock market indices).
The remainder of this article describes a “ballpark” formula that can be used to calculate the performance of individual investments or an entire investment portfolio. Using the result, you can then determine whether or not you actually “beat the market.” Surprisingly, the math needed to do this calculation is very simple. All you need to know is your portfolio balance at the beginning and end of a particular year (e.g., 2007) and the amount invested throughout that year. The amount held in all types of assets (e.g., stock, CDs) can be combined into one calculation for your entire portfolio or you can calculate the performance of each investment separately.
For example, in the illustration below, let’s assume that an investor started the year out on January 1 with a $15,000 balance in three investment accounts (e.g., a stock index mutual fund, a 401(k) invested primarily in equities, and a bank CD). By December 31 of that same year, the combined balance in these accounts had grown to $20,000. In addition, the investor added $100 a month to both the 401(k) and the mutual fund ($200 total) for a total investment deposit throughout the year of $2,400 (12 months x $200).
To calculate your portfolio return, take the beginning balance ($15,000) and add to it half of the total annual deposits ($1,200) for a total of $16,200. Then take the ending balance ($20,000) and subtract half of the total annual deposits ($1,200) for a total of $18,800.
Finally, divide the adjusted ending balance ($18,800) by the adjusted beginning balance ($16,200), which equals 1.16. Then, to turn the number into a percentage, subtract 1 and multiply by 100 (1.16 –1 x 100 = 16). In this example, the investor’s return on the entire portfolio, consisting of the three different assets, was 16%.
It’s that easy to estimate your investment return. Then you’ll know for sure whether you actually “beat the market.” January is a great time to do this calculation. The “holiday rush” will be over and you’ll be receiving year-end statements for financial accounts for income tax purposes. As you begin to receive these end-of-the year tax statements, you’ll have all the information that you need. Best wishes for a happy holiday season and a prosperous new year.