If you’re like most people, your investment portfolio’s performance is the most important gauge of how well you’re doing in the market and informs the kinds of returns you might expect in the years to come.
But how exactly do you get an accurate picture of your portfolio’s performance?
Calculating the rate of return may seem like a pretty daunting task. That’s especially true when you look at the relatively intimidating formulas used in doing so. However, as you’ll find below, performance calculations are actually relatively simple once you get in the swing of things.
The Portfolio Return Formula
There are multiple metrics you can use to calculate recent performance as well as future growth potential.
One of the most commonly used calculations for investment returns is known as the portfolio return formula. Not only can you use this formula in its traditional sense to measure your investment success, or lack thereof, it can be expanded to account for inflows and outflows of cash.
In the portfolio return formula above, RP stands for return of the portfolio, w stands for weight of investment, sigma n is the sum of the number of data points, r stands for rate of return of investment, and i stands for individual value.
To find an accurate total return, you’ll need to find the weight and return of each individual asset in your portfolio, then determine the weighted average of all individual returns.
How to Calculate Investment Performance (With the Portfolio Return Formula)
1. Calculate Expected Return for a Single Investment
Most portfolios are centered around diversification, consisting of several individual investments. The first step to determining your portfolio’s return — and therefore, its expected return in the future — is to assess each individual asset in the portfolio.
To do so, you’ll need the following:
- Initial Investment Cost. Include all costs of the investment, including the price of the asset when it was purchased, brokerage fees, and any other fees associated with the investment.
- Market Value. Next, you’ll need the current market value to determine the individual asset returns.
Now that you have both of these figures, use the following formula to calculate your return:
IR = (MV ÷ II) – 1
- IR is individual asset return;
- MV is the current market value of the asset; and
- II is the initial investment cost.
For example, if you invested $10,000 in ABC stock and your investment grew to $11,000, the equation would result in an individual asset return of 10% and look like this:
10% = ($11,000 ÷ $10,000) -1
Rinse and repeat the process until you know the returns of each individual asset in your portfolio.
2. Find the Portfolio Weight of Each Asset
In order to determine the performance of your whole portfolio, you’ll need to know the weight of each asset, or the percentage of the portfolio that’s allocated to each asset. To do so, use the following formula:
Asset Value ÷ Total Portfolio Value = Weight
So, keeping with the example above, if the $11,000 worth of ABC stock is part of a $100,000 portfolio, the equation would look like this:
$11,000 ÷ $100,000 = 11% weight
Rinse and repeat until you know the weight of each individual asset in your portfolio.
3. Calculate the Expected Return of a Portfolio
Now that you know the rate of return and weight of each asset in your portfolio, you have everything you’ll need to determine the weighted return of your entire portfolio. The best way to calculate this is in a spreadsheet like Microsoft Excel or Google Sheets.
Here’s how to set up your sheet:
- Column A. Asset Name.
- Column B. Asset Value.
- Column C. Asset Weight.
- Column D. Asset Returns.
- Column E. Asset Weighted Returns.
Once you’ve named your columns, fill out the data in columns A and B using a new row for each individual investment in your portfolio. For example, if you’ve got investments in ABC stock, XYZ stock, JOSH stock, DEF mutual fund, and GHI exchange-traded fund (ETF), your spreadsheet might look like this:
Next, you’ll need to add in the returns on your individual assets. Once you do so, your spreadsheet will look something like this:
Now, it’s time to add in weighted return calculations for each asset. To do so, you’ll need to multiply the portfolio weight by the asset returns. In the first open space in column E, type =C2*D2 and hit enter to have the software multiply these two values. This is the weighted return of the first asset in your spreadsheet.
Now, simply copy the cell and paste the formula into the cells in the E column next to each asset. When you do, your spreadsheet will look like this:
Now, it’s time to take all this data and turn it into the average return across your entire portfolio. To do so, use the SUM function to add up all the weighted asset returns. When you do, you’ll see your total weighted portfolio return, which is 9.23% in our example.
4. Add Cash Flow to the Mix
There is one significant problem with this formula: It doesn’t account for cash flows. If you contribute new money to your investment portfolio, those contributions will appear to inflate the returns. On the other hand, when you take money out of your portfolio, the deductions will result in artificially deflated returns.
That fact makes the traditional portfolio return formula best when determining the returns on a portfolio that hasn’t seen any contributions or deductions during the time period being covered. If there have been contributions or deductions, you’ll want to calculate each individual asset’s return using the money-weighted return rate calculation.
Holding Period Returns – A Simple Approach to Gauging Portfolio Performance
Another way to go about assessing the return of your portfolio — and arguably the most simple — is to calculate holding period returns, or the returns generated in your portfolio throughout the time you’ve held positions within it. The formula for doing so is:
(Income + (End of Period Value – Initial Value)) ÷ Initial Value = Holding Period Return
For example, let’s say you started an investment with $5,000. Over the course of a year, you collected $53 in dividends, and the value of the investments in your portfolio rose to $5,480. In this case, the formula to determine your total portfolio returns is as follows:
($53 + ($5,480 – $5,000)) ÷ $5,000 = 10.66% HPR
Not only is this a simplified way to see how your portfolio is performing and what you can expect in the future, it does what the more complex portfolio return formula doesn’t do — it accounts for income from dividend and bond coupon payments.
Calculating Annualized Returns
Rate of return calculations can be used over any time period, and the holding period you look at makes a huge difference.
For example, if I were to say the 9.23% return in the portfolio above was generated in one month, you’d likely be interested in how that was done. On the other hand, if I said the 9.23% return was generated over the course of five years, the returns would seem lackluster.
The best way to drown out the noise of time is to always focus on annual returns.
To determine annualized returns, use the steps above to determine your rate of return for each year you’re working to assess. Then average each annual return by adding them together and dividing the sum by the total number of years you’re assessing. This will result in the average annualized return over the period of time that interests you.
Why You Should Calculate Your Expected Return
Keeping tabs on the performance of your portfolio is important because it shows you how hard your money is working for you and how hard it’s likely to work for you in the future. If you’re not keeping track of your returns, your investments may be experiencing lackluster performance compared to major benchmarks like the S&P 500.
By calculating your returns, you’ll know whether your portfolio is doing well, and if it’s not, you’ll see which assets in your portfolio are underperforming and which are delivering. This gives you the opportunity to exit your positions in underperforming assets and open new positions in assets known to produce compelling returns.
Ultimately, it’s all about opportunity cost. Why would you accept menial gains when you have the opportunity to produce returns at or above market averages?
Limitations of Performance Measurements
There are a few significant limitations you should consider when assessing your portfolio’s performance:
Performance Metrics are Based on Historical Data
Any metric used to determine the performance of an asset, or entire portfolio for that matter, depends on historical data. The general belief is that history in the stock market tends to repeat itself, and for the most part, that’s true. Stocks that perform well over long periods of time are likely to continue to perform well for the foreseeable future.
However, although the idea tends to hold up, it’s not 100% accurate. If history was always indicative of the future, everyone would be rich by simply investing in the stock that historically performed the best. A stock that climbed 50% last year is not guaranteed to do the same this year.
Cash Flows Aren’t Accounted For
Most performance metrics don’t account for inflows or outflows of cash when determining the performance of your portfolio. Without accounting for cash flows, if there have been contributions or withdrawals into or out of your portfolio during the time period in which performance is being assessed, the results of your calculations may appear artificially inflated or deflated.
Income Should Be Included
Income generated through an investment should be included in any calculation of its performance. Unfortunately, income is nowhere to be found in the portfolio return formula.
One way to address this issue is to add any income you’ve received to the current value of assets in the calculation.
For example, if you own $10,000 of ABC stock and received $250 in cash dividend payments, using the portfolio return formula you could use $10,250 as the current value of ABC stock to account for the dividends you’ve received. The cash from the dividend is no longer baked into ABC’s share price, but you can keep track of it yourself.
While the formula for calculating your returns may seem intimidating, you’ll quickly get the hang of it once you start. It’s important to take the time and get to know just how well your portfolio is doing, because if it’s not doing well, addressing the issues as quickly as possible will make a huge difference in your long-term returns.
Never forget the power of compounding gains!
If you haven’t assessed your portfolio in a while, now is the time to review it. Then, include performance evaluations as part of your regular rebalancing efforts.