Ask DWM: “Please Explain how Investment Returns are Calculated”

Excellent question from a valued client and an extremely important one.  You need to know how your investments are performing.  Are you on track to meet your goals?  Are any changes needed?

To start, focus on your “total return.” In simplest terms, this is the total increase in your portfolio for the period. Let’s say you had $100,000 in one account at the beginning of the year and you didn’t add money or subtract any money during the year. At the end of the year, this account has grown to $111,820.  Your total return is $11,820 ($111,820 ending value minus $100,000 beginning value).  This is an 11.82% total return ($11,820 divided by $100,000).

Next, let’s drill down a little further.   The total return is composed primarily of two parts; the change in market value during the period plus dividends and/or interest earned.  Let’s assume, for simplicity sake, that this $100,000 portfolio only had one investment on January 1, 2016 and it was invested entirely in the Schwab S&P 500 Index Fund (SWPPX).  Those shares were valued at $31.56 per share at the beginning of that year- 3,168 shares with a total value of $100,000 (3,168 times $31.56).   Here is what actually happened with those shares in 2016:  Their value went up to $34.42. The $2.86 per share increase ($34.42-$31.56) amounted to a $9,062 increase in value.  And, in December, dividends were paid totaling 87 cents per share, a total of $2,758.  So, the account increased by a total of $11,820, of which there was a $9,062 price increase (9.1%) and a $2,758 (2.7%) dividend return.  Overall, an 11.82% total return for 2016.

Dividends and interest are the income received for holding the security and are called the “yield.”   Some investors focus on a high yield and ignore the potential impact of market increases or decreases.  We believe that is a mistake.  Historically, there are times, such as periods of low inflation, when dividend-paying stocks have outperformed.   And, there are times, such as the 1990s, when tech stocks with limited earnings and no dividends outpaced dividend payers by nearly 5% per annum.  Focus on total return (and, of course, diversification).

Now, let’s look at the situation where money is added or subtracted from the investment portfolio during the year.  When this happens, the performance results are generally calculated and shown as “time-weighted returns” which eliminates the impact of money coming in or going out and focuses on daily returns. Our DWM/Orion reporting system calculates the daily return for each holding and multiplies the daily returns geometrically to determine the time-weighted return.

The DWM/Orion reports show gross total returns for all holdings and asset classes and deduct management fees in calculating the time-weighted return.  Furthermore, reports covering a period of less than a year are not annualized.  For example, if the time-weighted return for the first three months is 2%, the report shows 2% and does not annualize that number (assuming the next three quarters will be similar results) and show an 8% annualized return.  However, on reports covering a period of more than one year, the overall results are reduced to annual amounts.  For example, if a performance report covering a three-year period shows a time-weighted return of 6%, then the overall return for that total period is approximately 18%.

The CFA Institute, the global association of vetted investment professionals, including Brett and me, which sets the standard for professional excellence and integrity identifies clear, trustworthy investment reporting as the most valuable tool for communicating investment information.  Early on, we at DWM determined that we and our clients needed a robust reporting system to calculate, help monitor and report on your investments.  Schwab as custodian provides regular statements for each account showing balances and activity during a given period. However, the statements don’t show performance vs. benchmarks on a percentage basis.  It also only shows one account at a time. Our DWM/Orion reporting system can show you performance at various levels: asset, asset class, account and household for a more complete, holistic review.

In today’s world, when there is so much data and so much news and much is either fake or biased, it’s important to know that your investment returns with DWM are calculated in an objective basis and compared to benchmarks for any time period.  This allows proper monitoring and facilitates modifications, when needed.

Thanks again for the question and let us know if there are any follow-up questions.

Testing Your Financial Plan

investment allocation, financial stress testFrom The Charleston Mercury, October 18:

Investment returns through September 30th have been quite good. Equity indices are up 13-16%, fixed income indices up 4-6% and liquid alternative funds are generally between the two. So, depending on your asset allocation, your portfolios may be up 6-12% or more year-to-date. Good stuff. 

The question, though, is when you’re doing your financial planning should you assume returns for the first nine months of 2012 will continue indefinitely or use some other numbers? Furthermore, when you do your financial planning how do you factor in unknowns that could derail your financial future? How do you develop and stress test your financial plan so you can sleep at night?

Let’s start with investment returns, the real “engine” of your financial plan. Asset allocation, of course, is the primary factor that determines performance. Despite the stock market’s recent results, the world and the investment landscape seem very uncertain these days. Is your asset allocation designed to protect and grow the assets you need for your successful financial plan? You’ll need to develop an estimated return for your allocation. Historical returns cannot predict the future but give you some direction. Should historical returns go back to 1926? The last decade? Last five years? These days it’s impossible to find a perfectly representative period given the worldwide changes in the last decade and the changes that are occurring every day. Even so, you’ll need to develop a realistic value as a starting point.

Calculate your planning by using your key variables, including assets, investment returns, expenses, inflation and eventual age and develop not just one result but a series of results for your plan. It will show how variations in rates of return each year can affect your results. 

This method is called a Monte Carlo simulation and it calculates the results of your plan by running it many times, each time using a different sequence of returns. Some sequences produce better results, some worse.  Ultimately, the simulation will produce a range of possible results with probabilities of success for a given set of variables.

Next, you will want to stress test these results by considering what happens if bad things occur. Some of the key “what ifs” are:

  • Inflation will be higher
  • You outlive your assets
  • Social security benefits are cut
  • Investment returns are less than expected
  • You incur uninsured health care costs

The Monte Carlo simulation is highly valuable in that it will be able to show you the probability of success of your financial plan if one or any combination of these stress test events occurs.

Stress test your financial plan. You’ll sleep better at night.

Lester Detterbeck is one of a small number of investment professionals in the country who has attained CPA, CFP®, and CFA designations. His firm, DWM Financial Group, Inc., a fee-only Registered Investment Adviser, has offices in Charleston/Mt. Pleasant and Chicago. Les may be contacted at (843)577-2463 or les@dwmgmt.com

Charleston Mercury: Six Keys to Financial Independence

From the Charleston Mercury July 26, 2012

Ever worry about running out of money during your lifetime? Many people do these days. The primary concerns seem to be the likelihood of living longer, reduced investment returns and future inflation.  Here are six rules of thumb, which followed, can help immensely:

1) If you are retired, limit annual withdrawals from your investment pot to 4%. This assumes an annual investment return of 5.5%, inflation of 3%, and the individual(s) withdrawing money for up to 30 years or more. A 65 year old couple, newly retired, with an investment portfolio of $1 million should be able to safely withdraw $40,000 in year one and 3% more each year thereafter. Note: a withdrawal rate of 6% will dissipate this investment pot in roughly twenty years.

2) If you are still working, target an investment pot equal to 25 times your expected annual withdrawals during retirement. A couple expecting to need $60,000 of annual withdrawals from their investments upon retiring at age 65, for example, will need to save and accumulate $1.5 million. Please note that annual withdrawals are calculated by adding all expenses, including taxes and then subtracting income such as social security, pensions, part-time employment, etc. Inflation must be included in the calculation.

3) Your annual investment returns need to exceed inflation by at least 2-3% per year. If not, your investment pot will vanish quickly. Currently, inflation has been running at roughly 2.5%. If inflation increases, then investment returns need to as well.

4) Focus on your housing decisions. The total cost of housing includes taxes, mortgages, maintenance, insurance and opportunity costs for the non-invested equity in the house. These costs can be 8-10% of the value of the house per year. In addition, your house may have substantial equity which may need to be “unlocked” in the future.

5) Control your expenses. Expenses are the most controllable factor in determining whether or not you will accumulate a sufficient nest egg and/or run out money. We all have the opportunity and responsibility to determine how we spend, save and invest our money. These decisions result in spending levels which directly impact the amount of our nest eggs and whether we outlive our money.

6) Don’t forget insurance and risk management. Negative financial surprises can destroy an otherwise solid financial plan for the future.

So, now it’s time for self-evaluation. If you’re in retirement, is your withdrawal rate sustainable? If you’re working, are you on track to meet your investment nest egg goals? What’s the return on your investments over the last 1, 3 and 5 year periods? Are you beating inflation? Can you afford your house? Will you need to tap into its equity at some point? Are your expenses under control? Do you monitor and review your expenses regularly? When was the last time you had an independent review of your insurance and risk management? Do you have the right coverages and are you paying the right amounts?

Finally, if your self-evaluation has added more worry than peace of mind concerning your financial future, do find the best financial counsel available.

Lester Detterbeck is one of a small number of investment professionals in the country who has attained CPA, CFP® and CFA designations.  His firm, DWM Financial Group, Inc., a fee-only Registered Investment Adviser, has offices in Charleston/Mt.Pleasant and Chicago.  Les may be contacted at 843-577-2463 or les@dwmgmt.com.