Investment Performance Analysis

It seems like it should be easy to calculate a percentage return. The formula should be something like this: ending value minus beginning value equals gains. Gains divided by beginning value is a percentage gain. Right?

Right…but what about the timeframe? The calculation becomes different when you want to know what percentage per year (annualized performance) you have earned. And it is really different if you want to know other timeframes—our websites allow you to choose any timeframe you want.

It gets more complicated in the real world because of cashflow. What happens when you are adding (or withdrawing) money to the account? The calculation becomes much more complicated when you add different dollars at different points in time. Do you start tracking each deposit/withdrawal separately?

What do you compare it to? How do you compare your account’s performance to a benchmark index or another mutual fund or a group of investments? To do that, you have to know all of the information above: dates, dollars in, dollars out, for all of your investments. You have to know it for all of the investments you want to compare. Plus, as discussed elsewhere, you have to know where else you could have been invested; they call this cost of capital, and/or the safe money rates of return.

Fortunately, our websites will do all this work for you. And the more you learn, the more you will understand the information you will receive.

For all the reasons outlined above, performance calculations are more complex than they first appear. We discuss different ways to calculate performance. Each method has advantages and disadvantages. And not every investment company calculates returns the same way. First, we look at the method our providers use, called the “IRR.”

Our providers use the Internal Rate of Return (IRR) Calculation method. The Internal Rate of Return (IRR) is used to calculate the money-weighted rate of return. Like the Modified Dietz calculation, discussed elsewhere, we value the portfolio at the starting and ending points of the period. Cash flows are included based on their timing.

The IRR is related to the time-value of money or present value formula. It calculates the discount rate which will take the starting value and all cash flows to result in the ending market value. This type of calculation looks at the actual returns on dividends, sales or other deposits, which is a clear difference from the other types of performance calculations.

Large cashflows dominate small cashflows—they have a much larger effect on your percentage returns. Similarly, the most recent period of time dominates returns—for better or worse. Keeping money in cash hurts returns because the cash is included in the calculation—this is different than the two other methods, discussed next.

To be clear, the providers we use for performance reporting show the internal rate of return (IRR), not any other calculation.

Mutual funds and some other large investment companies use a performance calculation regulated by an international organization called GIPS. That organization requires these types of companies to use a performance calculation called Modified Dietz. To be clear, mutual funds do not calculate performance like you and I calculate performance.

The Modified Dietz calculation is useful for businesses and financial managers who are looking at a project. It is often shortened to the abbreviation MIRR: Modified Internal Rate of Return. From an investment standpoint, MIRR makes an assumption that any money an investor adds to the portfolio (or receives from a dividend or other means) is reinvested at “the firm’s cost of capital.”

For investors like you and I, who are people, the cost of capital is a largely irrelevant. If we did try to figure it out, each person’s cost of capital would be completely unique. For example, if you have a mortgage and you have investments, you could consider your cost of capital the same as your mortgage rate. Keeping money in cash, when it could pay off the mortgage, costs you a little bit of interest.

If you compare your personal returns with a mutual fund’s return, you are not comparing apples to apples. Performance may be over- or under-stated.

A quick note on a third type of investment performance calculation used in real estate, and REITs, but not used by us. It is called the financial management rate of return. This way to calculate performance includes the “cost of capital” and adds a third type of reinvestment, called the safe rate. Why do they do this?

Because a real estate investor who receives cash has at least three rates of return (or costs they must pay) on the cash. They might (but probably will not) earn a (hopefully high) appreciation rate on their real estate, they might earn (or pay) the cost of capital, or they might earn the (low) safe rate of return in a bank or wherever.

Again, for the real world, individual investor, the situation is unique. So we want to be careful when we compare these returns to those returns, because they may not be an apples-to-apples comparison.

To summarize, we use IRR to report performance. It takes into consideration your deposits, withdrawals, and the passing of time. IRR is the most accurate calculation for our clients. It is also a more complicated calculation than most of us would do on our own.

Mutual funds and a large number of other investment companies usually use the Modified Dietz method. REITs and large, professional real estate companies use FMRR.

Understanding the decades of thoughtfulness that went into the different calculations may help you feel a little humble, and also empowered.