How to Calculate Your Portfolio's Investment Returns

An investor's primary goal is to make money. 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.

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. They also need to consider opportunity costs: an asset with high potential returns might seem less attractive if the same money can be spent more profitably on other investments.

Calculating Returns for a Single Investment

The next step is learning to calculate the return on investment (ROI) for each asset. This metric can quantitatively measure how effectively a given asset is putting your money to work.

The ROI of a single investment is calculated by dividing the net price gain from holding the asset by the asset's original cost. The cost of an asset includes not only the purchase price, but also any commissions, management fees, or other expenses associated with the acquisition. The resulting fraction represents the gain in value as a percentage of the asset's price.

Although it's not a perfect science, this is a crude gauge of how effective an investment performs relative to an entire portfolio.

Calculating Returns for an Entire Portfolio

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. After all, there are market forces at play that can impact the performance of any asset, including economic factors, political forces, market sentiment, and even corporate actions. But that doesn't mean you shouldn't work out the figures.

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 institutions.

The first step is to list each type of asset in a spreadsheet, along with their calculated ROI, dividends, cash flows, 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, including 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

The last two sets of figures can be used to estimate portfolio returns: Multiply the ROI of each asset by its portfolio weight. The sum of these figures is the portfolio's estimated returns.

Other Factors

While the above is a popular and straightforward method of estimating 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.

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 also need to strike a net asset value (NAV) of each position in each portfolio for the time periods and note any cash flows, if applicable.

Holding Period Return

Once you define your time periods and sum up the portfolio NAV, you can start making your calculations. The way to calculate a basic return is called the holding period return.

Here's the formula to calculate the holding period return:

• HPR = Income + (End of Period Value - Initial Value) ÷ Initial Value

This return or yield is a useful tool to compare returns on investments held for different periods of time. It calculates the percentage difference from period to period of the total portfolio NAV and includes income from dividends or interest. In essence, it's the total return from holding a portfolio of assets—or a 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 portfolio(s). 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 when you calculate a monthly return. This can be adjusted using various calculations, depending on the circumstances.

The modified Dietz method is a popular formula to adjust for cash flows. Using an internal rate of return (IRR) calculation with a financial calculator is also an effective way to adjust returns for cash flows. IRR is a discount rate that makes the net present value zero. It is used to measure the potential profitability of an investment.

Annualizing Returns

A common practice is to annualize returns for multi-period returns. 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 had been compounded. The annualized return does not give an indication of volatility experienced during the corresponding time period. That volatility can be better measured using standard deviation, which measures how data is dispersed relative to its mean.

Example of Calculating Portfolio Returns

The total amount of the investment positions in a brokerage account was $10,000 at the start of the year and $13,350 at year-end.

• A dividend was paid on June 30 for $500.
• The account owner paid $150 in fees and commissions.

ROI = (Net gain on investment + dividends - fees) / Initial cost of investment

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 any fees or commissions as shown below:

• ROI net gain = $13,350 - $10,000 + $500 - $150 = $3,700

The next step is to take the net gain and divide it by the initial investment amount, as shown below:

• ROI = $3,700 / $10,000 = .37 or a 37% gain (.37*100 to convert to a percentage)

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. In that case, you could subtract out any deposits and add back in 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, the ending year balance would be $18,350 (versus $13,350). Without accounting for the deposit, the rate of return wouldn't be accurate since it would appear that the account earned $8,350 in market gains and dividends—not including any fees or commissions. 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 the power of compounding, meaning earning interest or gains on reinvested dividends.