 Personal Finance Powerpoint Presentation. Investment Returns Calculation. Prepare to get financially fit by practicing personal finance. Most of this information comes from Investopedia, how to calculate your portfolio's investment returns, which you can find online. Take a look at the references, resources, continue your research from there. This by Nick Loedis, updated February 6, 2022. In prior presentations, we've been taking a look at investment goals, investment strategies, investment tools, keeping in mind the two major categories of investments typically being fixed income, generally bonds, and then equities, typically stocks. We're looking now at how to calculate your portfolio's investment returns. So an investor's primary goal is to make money, so we're trying to make our money, make money for us, put the money to work people. So although you can't predict how your investment portfolio will perform, there are several metrics that investors can use to calculate a realistic estimate of future growth. So clearly what we would want to do then is to try to predict how much our investments might be able to earn, try to budget that out, try to make predictions and think about what's going to happen in the future. And as time passes, we would like to calculate how much we actually got in return to see some comparisons to what we thought might happen. So not only do investors need to consider the expected gains of each asset, but they also have to consider factors such as downside risk, market conditions, and the length of time it will take for each investment to realize returns. So we've got to think about our time horizon, what's going to be the risk that will be involved, what are the market conditions that we're currently in. They also need to consider opportunity costs. Opportunity costs being the costs of the next best thing that we could do. Economists will say that everything has a cost because anything you choose to do means that you chose not to do the next best thing. Clearly with money, anything you put your money into means that you chose not to put your money in the next best thing, that being a form of opportunity cost. So an asset with high potential returns might seem less attractive if the same money can be spent more profitably on other investments. So calculating returns for a single investment, the next step is learning to calculate the return on investment that's otherwise known as the ROI for each asset. This metric can quantitatively measure how effectively a given asset is put in your money to work. So obviously when we're making calculations, we want to be as specific as possible. Whenever someone tells you they've got a goal that they're going to be doing and they give you some vague language like some bureaucrat or politician or something, that's not very helpful. As much as possible, we'd like to actually be able to measure the performance and we'd like to put some metrics down, not that everything could be measured that way. But if we could do it, that's what we want to try to do. So the ROI, the return on investment of a single investment is calculated by dividing the net price gain from holding the assets by the asset's original cost. So once again, we're looking at the gain over or divided by the cost. So the cost of an asset includes not only the purchase price but also any commissions, management fees and other expenses associated with the acquisition. The resulting fraction represents the gain in value as a percentage of the asset's price. So now when we look at these percentages, they can be a little bit confusing. A lot of people are intimidated by percentages and ratio kind of calculations. But we have to use those kind of calculations in many different ways. If you're in an employment or something like that, you might find that when they're trying to judge your performance and stuff, you have to use ratio analysis. We do the same thing when judging the performance of say athletes, when we look at their stats for baseball players and so on and so forth. For example, that's the only way we can accurately do it. And so we've got to have some concept of these ratios. So if you look at a ratio like the return on investment, you might be able to compare and contrast a little bit more easily, get more information from the comparison than you could comparing two different types of investments, especially if those investments had different dollar amounts that it costs to invest in them. So although it's not a perfect science, this is a crude gauge of how effective an investment performs relative to an entire portfolio. So calculating returns for an entire portfolio. So obviously we in a portfolio are going to have a bunch of investments involved. We want to think about, okay, what's our overall kind of return on the portfolio, all of our stuff, all the action that we have going on. So as mentioned above, there are uncertainties that come with investing. So you won't necessarily be able to predict how much money you'll make or whether you'll make any at all. Really, it's all an estimate when you're trying to predict the future, but you want to make some budgeting goals, typically. After all, there are market forces at play that can impact the performance of any asset, including economic factors, political factors, market sentiment, and even corporate action, so actions. So, but that doesn't mean we shouldn't work out the figures. So working out the returns on individual investments can be an exhaustive feat, especially if you have your money spread across different investment vehicles maintained by various firms and industries. So just from a practical standpoint, you might start to think about, okay, I can see this from a stock by stock type of thing, but if I'm investing in a bunch of different stocks or I've got my money in a mutual fund, I've got my money in a mutual fund or possibly multiple different financial institutions, then you could see how you might want to apply these factors to individual stocks in some cases, or trying to apply this kind of to a group of investments that you're basically putting in place, trying to value your full portfolio. And you might be looking at different portfolios that are now managed under different funds or by different financial institutions or some ways that you might try to group this stuff together so you can think about the valuation from a practical standpoint. So the first step is to list each type of asset in a spreadsheet along with their calculated ROI return on investment, dividends, cash flow management fees, and other figures relevant to the cost or returns of those assets. You'll need to know the following. The total cost of each investment included any fees and commissions, the historical returns of each investment, the portfolio weight of each investment represented as a percentage of the portfolio's total value. In other words, you can think about kind of like a pie chart type of calculation. If you've got your total assets, you can think about each of those individual assets as a percentage or related to the total. So you would take each individual asset divided by the total and you would get a ratio of that asset as compared to your total investments. So the last two sets of figures can be used to establish portfolio returns, multiply the ROI return on investment of each asset by its portfolio weight. So the sum of these figures is the portfolio's estimated returns. So other factors, while the above is a popular and straightforward method of estimated portfolio returns, it does not reflect other important factors such as the holding period for each asset or the additional returns from bond payments or stock dividends. So now when we take a general concept like that, we're not taking into consideration how long we're going to be holding the assets. And then of course, when you've got the payouts of future payouts like bond payments and dividends that can add a level of complexity with regards to the cash flow related to them, if we wanted to get a little bit more detailed. In order to account for these factors, you'll want to consider a few things. The first is to define the time period over which you want to calculate returns daily, weekly, monthly, quarterly or annually. You'll also need to strike a net asset value that's the NAV of each position in each portfolio for the time period and note any cash flows if applicable. Holding period return. Once you define your time periods and sum up the portfolios NAV, you can start making your calculations. The way to calculate a basic return is called the holding period return. We might do some practice problems on these by the way, just so you could get a visual concept of these. But in any case, here's the formula to calculate the holding period return. You've got the HPR equals income plus end of period value minus the initial value divided by the initial value. This return or yield is a useful tool to compare returns on investments held for different periods of time. So it calculates the percentage difference from period to period of the total portfolio NAV and calculates income from dividends or interest. In essence, it's the total return from holding a portfolio of assets or singular asset over a specific period of time. Adjusting for cash flows. You will need to adjust for the timing and amount of cash flows if money was deposited or withdrawn from your portfolios. So you've got the cash flows now, the holdings themselves and the money or cash flows going into and out of them. So if you deposited $100 in your account mid month, the portfolio end of month NAV has an additional $100 that was not due to investment returns. So clearly you don't want to put that $100 as if it was a return on investment because it wasn't. You put more money into it when you calculate the monthly return. So this can be adjusted using various calculations depending on the circumstances. So the modified Diaz method is a popular formula to adjust for cash flows using an internal rate of return, an IRR calculation. There's a tool to use that on Excel so we might kind of jump into Excel and show you some of these tools later. With a financial calculator is also an effective way to adjust returns for cash flows. So IRR is a discount rate that makes the net present value zero. It is used to measure the potential profitability of an investment. Analyzing returns, a common practice is to annualize returns for multi-period returns. So we might try to make an annualized method. This is done to make the returns more comparable across other portfolios or potential investments. It allows for a common denominator when comparing returns. An annualized return is a geometric average of the amount of money an investment earns each year. It shows what could have been earned over a period of time if the returns have been compounded. The annualized return does not give an indication of volatility experienced during the corresponding time period because now you don't have as much detail because you're annualizing them. So the volatility can be better measured using standard deviation, which measures how data is dispersed relative to its means. So again, we might dive into a little bit more of those calculations in some examples. So example of calculating portfolio returns. So the total amount of investment positions in a brokerage account was $10,000 at the start of the year and $13,350 at year end. Okay, so the dividend was on June 30th for $500, so now we got cash flow dividend coming in. So the account owner paid $150 in fees and commissions, so that's cash going out for the cost. The ROI return on investment would be the net gain on investment plus dividends minus the fees, so that divided by the initial cost of investment. So the first step is to take the total gain for the year and subtract the initial investment amount, then add in the dividend and subtract out the fees or commissions as shown above. So ROI net gain, we got the $13,350, that's the year end amount, minus the $10,000, which was the amount that was the cost, plus we had $500 coming in from the dividend, minus we had the $150 in fees, that's going to give us the $3,700. The next step is to take the net gain and divide it by the initial investment amount as shown below. The ROI return on investment then being the $3,700 divided by the cost of the $10,000, which equals 0.37 or a 37% gain, which is just 0.37 times 100. Move the decimal two places over. The above example is a straightforward way of calculating a portfolio's return. It's also essential to consider if money was added or withdrawn to ensure that the ending year account value and ultimately the rate of return is not skewed by those transactions. So in other words, when money is going in and out of the account, you don't want to be counting those as basically part of the gain or loss. You got to be careful with those transactions or else your ratio will be skewed incorrectly. In that case, you could subtract out any deposits and add back any withdrawals to recalculate the ending year balance to arrive at the rate of return based on market gains and dividends. Using the example above, if the account owner deposited $5,000 during the year, so we're adding a level of complexity, now we put more money in from basically our checking account or earnings into the investment $5,000, the ending year balance would now be $18,350 versus the $13,350. The difference wasn't gained, it was $5,000 that we put in ourselves. So without accounting for the deposit, the rate of return wouldn't be accurate since it would appear that the account earned $8,350. But obviously not because much of that was what we put in in market gains and dividends, not including any fees or commissions. So instead, the $5,000 deposit can be subtracted from the ending balance and the $13,350 would be used in the ROI formula. However, there are many ways to calculate the rate of return on a portfolio, including calculating on a quarterly or monthly basis to account for dividends and power of compounding, meaning earning interest or gains on reinvested dividends. So notice here, you're basically trying to pull out the money that you put in and you don't have that same kind of compounding calculation because you're trying to do it kind of like on an annual basis. So you might be able to kind of break it down into smaller periods would be one method that you could use on a month-by-month kind of method instead of on a yearly type of method, so you can use different approaches. So how can I calculate a portfolio's return? There are several methods to calculate a portfolio's return. The starting balance can be subtracted from the ending balance while also accounting for fees, commission, dividends, and cash flows. How can I calculate the return on investment for a portfolio? A portfolio's return on investment, otherwise known as ROI, can be calculated as follows, current or ending value minus initial value or starting balance divided by the initial value. To account for dividends and brokerage fees, current or ending value minus initial or starting value plus dividends minus fees divided by the initial value multiply the result by 100 or move the decimal two places to the right to make it from a decimal to a percent. So what is considered a good return on investment for a portfolio, you might ask. A good ROI return on investment for a portfolio depends on the investor's risk tolerance and time horizon. For example, a retiree might opt for more stable investments such as bonds. Conversely, a person in their 30s might opt for more equities since they can have a longer time horizon to make up for bear markets allowing for a higher risk tolerance than a retiree. So we talked about what kind of returns you would be looking for will be dependent upon in part your time horizon and so you have to make your comparisons appropriately given those restraints, your risk tolerance, your time horizon and so on. So as a result, it's important to compare a portfolio to similar investments and equity portfolio compared to the performance of the S&P 500 index and a bond portfolio compared to the bond market. So in other words, you might be looking at your portfolio and trying to be comparing them to relevant benchmarks such as the averages taken in the market like an S&P 500 which would be something to compare your stock investments to possibly to see if you're outperforming or not outpacing like the S&P or the bond market on the case of fixed income.