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THE TRIALS AND TRIBULATIONS OF MEASURING AND
COMPARING INVESTMENT PERFORMANCE
Measuring and comparing investment performance is not an easy
task. Consider, for instance, something as simple as the daily
comings and going of the stock market. One month the Dow Jones
industrial average (DJIA) is up and the next month it's down.
But do those changes really tell the whole story?
Not really. The continuous changes in the DJIA merely
represent the change in the market value of the 30 stocks that
make up the DJIA. The actual change would reflect not just the
change in market value but the income from the dividends from
the companies comprising the Dow. And since the DJIA currently
has a dividend yield of 2.5 percent, the actual investment
performance, or what some refer to as the actual total return of
30 stocks in the Dow, would be different from what is typically
reported based only on price changes. In addition, the DJIA is a
"price weighted" index, so that higher priced stocks
have a higher impact on index performance. Most of the other
common indexes are "market weighted," reflecting the
relative market composition of the stocks in the index.
So what then are some of the best ways investors and planners
should measure and compare investment performance?
According to Herbert Mayo, author of a time-honored textbook on
the subject of investments, the simplest way to calculate a
return on an investment is by considering the flow of income,
such as dividends, plus price gains (or loss) relative to the
amount invested for a given holding period. So for example, if a
person buys a share of stock for $40, collects a $2 dividend and
then sells the stock for $50, the holding period return would be
($50 + $2 - $40) divided by $40. Thus the holding period
"total" return would be 30 percent. A shortcoming of
holding period returns, however, is the failure to consider how
long it took to earn the return. After all, if the difference in
time between buying and selling is 10 weeks, then a 30 percent
return is great; if it is 10 years, 30 percent is not as
impressive.
According to Mayo, this problem is avoided by calculating the
so-called internal rate of return. A simple example of internal
rate of return is the yield to maturity on a bond. Yield to
maturity equates the present value of the cash flows (interest
payments and principal repayment) with the present cost of the
investment while assuming that interest income as received is
reinvested at the same (yet to be determined) yield. Though a
tad complicated, the key difference between a holding period
return and compound annual return is that the
latter return considers all cash inflows to an investor when
they occur and compares them with the cost of the investment.
But in comparing portfolio returns where money is being added
and subtracted from holdings, we must decide how to weight the
returns of the individual holdings. Weighting the performance of
each individual investment relative to the size of the
investment (a dollar-weighted return) may give predominant
weight to recent large investments and may not truly represent
portfolio performance over an extended holding period
An alternative to this misrepresentation on the part of a
dollar-weighted rate of return is the time-weighted rate of
return. Simply computing the average of a series of returns can
also be misleading. So, for instance, if an investor buys a
stock for $40 and collects a $1 dividend in year one and the
stock closes the year at $42, the time-weighted return would be
($42 + $1 - $40) divided by $40, or 7.5 percent. If the investor
held that very same stock for another year, closing at $50 and
collecting another $1 dividend, the holding period return for
that year would be 21.43 percent, or ($50 + $1 - $42) divided by
$42. The simple average return would be 7.5 + 21.43 divided by 2
or 14.47 percent.
So which method of calculating is preferred? According to
Mayo, there is no absolute right answer. Typically, the investor
is concerned with the return earned on all the money invested,
making dollar-weighted the more preferred method. However, Mayo
says one can make the argument for the use of time-weighted
returns to evaluate the performance of portfolio managers. By
way of history, a study published in 1968 by what was then
called the Bank Administration Institute (BAI) suggested that
measurements of performance should be based on asset values
measured at market, not at cost; the returns should be
"total" returns; that is, they should include both
income and changes in market value (realized and unrealized
capital appreciation); the returns should be time weighted; and
the measurements should include risk as well as return.
No matter the method of calculating investment performance,
it's also especially important that planners and investors
compare the investment performance of their portfolios to
appropriate benchmarks. Typically, according to The Financial
Analyst's Handbook, there are three useful standards against
which portfolios can be measured, including comparison with an
absolute goal; comparison with market indexes, and comparison
with other portfolios. Of note, financial planners say that
dollar-weighted returns compare very poorly against benchmarks
when there are large cash flows; time-weighted returns are the
only ones that are really appropriate for benchmark comparison
purposes.
March 2006 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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