Figure out your rate of return

Let’s assume your portfolio had a balance of $100,000 at the beginning of 2011, with the money invested in a mix of four funds: $20,000 each in Canadian equity, U.S. equity, and international equity funds, and $40,000 in a Canadian bond fund. You add $2,500 on February 1 and take out $10,000 for an emergency on September 1. You end the year with $90,000. What is your return for the year? And should you be pleased with it?

1. Figure out your rate of return

If you have your account statements for the year, the first step is pretty simple. You can enter the market value of your portfolio at the beginning and end of the year, as well as the contribution and withdrawal, into our spreadsheet, which you can download at www.moneysense.ca/ror. This calculator will return the result of –2.53%.

You can also use any spreadsheet program (like Microsoft Excel or Google Docs) to do your own calculation with the XIRR function. Just enter the cash flows in column A and the dates in column B, as shown in Table 1 below. (Be sure to format column A as “Currency” as column B as “Date.”) Note that the initial value and any contributions are entered as a negative number. Think of it as money leaving your wallet and going into the portfolio. Withdrawals and the final portfolio value are entered as positive numbers.

Then click on an empty cell and type “=xirr(A1:A4,B1:B4)”. Format the cell where you typed this formula as “Percentage” and you should get the answer –2.53%. You can do this for as many transactions as you want over a number of years and the formula will always spit out an annualized figure.

Be aware that this formula is not foolproof. If the cash flows are large compared with the beginning and end values of the portfolio (this might occur if you’re a new investor who has just started making monthly contributions) the results will likely be wildly off. As the portfolio gets larger, and the contributions and withdrawals get relatively smaller, however, your personal rate of return will more closely resemble the reported performance of the underlying investments. This is why long-term comparisons are so important.

2. Determine your custom benchmark

Our sample portfolio includes several asset classes, so we need to use a combination of benchmarks. For example, our Canadian equity fund’s benchmark would be the S&P/TSX Composite Index. (For help determining the others, see “Which benchmark should I use?” on the next page.)

We calculate the return for the benchmark by multiplying the return of each index by its weighting. For 2011, the following four benchmarks and their returns are shown in Table 2.

To calculate the custom benchmark return, multiply the percentage of the portfolio in each asset class by the return for that asset class’s index:

= (20% x –8.7%) + (20% x 4.4%) + (20% x –9.7%) + (40% x 9.7%)

= 1.08%

Don’t worry, you don’t have to look up these index returns or make this calculation yourself. They’re built in to our downloadable spreadsheet. We also include three-, five-, and 10-year annualized returns.

3. Compare the two figures

In the real world, you can’t expect the same returns as the benchmark: index returns don’t factor in fees and transaction costs, and even low-cost index funds are not free. So if you’re a DIY investor (whether a Couch Potato or a stock picker), you should subtract about 0.50% from the annual performance of your benchmark to account for costs.

If you use a financial adviser who helps only with investment advice (and not financial planning), then you can subtract the same 0.50% from the annual benchmark performance. After all, if you’re hiring someone to help you earn higher returns than you could get with a Couch Potato portfolio and they’re not doing that, then you’re not getting any value.

If you use a financial adviser who also provides financial planning, then you should subtract an additional 1% (for a total of 1.50%) from the benchmark returns.

Going back to our example, your return of –2.53% is 3.61 percentage points off the benchmark return. Even after accounting for investment advice and financial planning, that’s very poor performance.

Now that you have a basis for comparing your results against your proper benchmark over short and long periods, you’ll know if you should be patting yourself on the back for your outstanding performance or asking questions about your strategy.

Which Benchmark Should I Use?

It’s important to compare your portfolio’s performance to an appropriate benchmark that includes the same asset mix. Below are some widely used indexes for major asset classes. Norbert Schlenker of Libra Investment Management maintains a useful spreadsheet of historical returns for these and other major indexes.

When evaluating the performance of individual funds (as opposed to your overall portfolio), you can drill down a bit further than the broad indexes. For example, if you have a Canadian equity fund that focuses on small companies, you may want to compare it to the S&P/TSX Small Cap Index. If you outperform the overall market but underperform the small-cap index, then you did well by choosing to be in small caps, but you did poorly picking individual small-cap stocks.

Another way to quickly assess your investment performance is to compare your funds or stocks to an index fund or ETF that tracks a comparable benchmark. That will give you an idea of whether your picks did better than a simple, low-cost, passive strategy.

For example, if your adviser recommended an emerging markets mutual fund, compare its performance to the iShares MSCI Emerging Markets Index Fund (XEM). Compare your Canadian stock picks to the iShares S&P/TSX Composite Index Fund (XIC).

The table at left lists Canadian index funds and ETFs that track major benchmark indexes. You can easily find performance information on each fund’s web page. Note that all published performance numbers include reinvested dividends (or interest, in the case of bonds).