The main point of investing is to make money. Although you can't predict how your investment portfolio will do, there are different metrics that can help you determine how far your money may go. One of those is called the return on investment (ROI), which can measure an investment's success. This is an important metric for any investor because It directly measures the return on that investment relative to its cost.
To calculate the ROI, divide the cost of the investment by its return. Although it's not a perfect science, this is a crude gauge of how effective an investment performs relative to an entire portfolio. But what if you want to know how well your that portfolio will do? Read on to learn how you can calculate its returns.
- To calculate your investment returns, gather the total cost of your investments and the average historical return, and define the time period for which you want to calculate your returns.
- You can use the holding period return to compare returns on investments held for different periods of time.
- You'll have to adjust for cash flows if money was deposited or withdrawn from your portfolio(s).
- Annualizing returns can make multi-period returns more comparable across other portfolios or potential investments.
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 a very exhaustive feat especially if you have your money spread across different investment vehicles that are maintained by a variety of different firms and institutions.
But before you calculate your investment returns, identify and gather the requisite data. You'll need to know the following:
- The total cost of your investments including any fees and commissions
- The average return for all your investments
Once you have the data prepared, you'll want to take a few things into consideration. The first thing is to define the time period over which you want to calculate returns—daily, weekly, monthly, quarterly, or annually. You 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.
Remember to define the time period for which you want to calculate your returns.
Holding Period Return
Once you define your time periods and sum up the portfolio NAV, you can start making your calculations. The simplest 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/yield is a useful tool to compare returns on investments held for different periods of time. It simply 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.
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.
An Example of Calculating Portfolio Returns
The sum total of the positions in a brokerage account is $1,000 at the beginning of the year and $1,350 at the end of the year. There was a dividend paid on June 30. The account owner deposited $100 on March 31. The return for the year is 16.3% after adjusting for the $100 cash flow into the portfolio one-quarter of the way through the year.