The return we make on our investments is a vital data point in determining how our financial plan is progressing and making buying, selling and rebalancing choices. All these decisions may go wrong if that basic returns number is not evaluated and understood correctly. Here is what you need to know so that you interpret and use the information provided by the return numbers to further your investment plan.
Look beyond the number
What you see published as the return number may not be what your investment earned. This is not because of any intention on the part of the investment provider to mislead you but because of the timing of your investment. Investment providers typically provide the compounded annual growth rate (CAGR) if the holding period is greater than one year or annualized return for periods of up to one year. If an investment has reported a return of 12% for a 3-year period, then you would have earned that only if you held the investment over the specified period. The CAGR is the rate at which the investment grew over the period under advertisement, say three years, and not the return that was earned each year. If your investment was held for any sub-sect of that 3-year period, say one year, you are unlikely to have earned the CAGR. It may be higher or lower than the CAGR.
Even if you held the investment for the same period, your return may be different from what is published if there was any activity in your account such as additional purchases or redemptions.
A 30% return on investment may sound impressive but consider the period over which it was earned. If it was earned over a 5-year holding period then the investment earned only around 5.4% per annum. Annualize returns to assess the performance of an investment and to compare it with other investments.
Consider dividends, interest
The total that you earn on your investment includes any periodic payouts such as dividends and interest along with an appreciation or depreciation in the value, irrespective of whether it is realized or not. Include these while calculating your return number.
Also, consider whether the periodic income you earned was re-invested or consumed. If it was re-invested then you have to compound this income because it is going to grow and contribute to the value of the holding.
Match period and investment
Evaluating historic returns is an important step. Some types of investments have steady returns. For example, returns from ultra-short term bond funds are not subject to much volatility. The one- or three-month return will give you a fair idea, unless there is significant change in interest rates.
But if you were looking at, say, an equity fund, then short-term returns can be misleading. A market rally may translate into very good short-term returns, but it cannot be extrapolated to returns likely over the long term. Long-term investments are best evaluated by historic long-term performance.
Annualizing short-term returns to be able to compare across investments may again give erroneous information if done for investments with volatile returns. For example, if you tried to estimate the annual returns based on the daily published stock prices, you are likely to be way off the mark.
Dig into return numbers
Evaluate the return to assess how your investment is being managed in products such as mutual funds.
As investors and potential investors, you would be interested in the consistency of performance and that it is in line with the investment objective. Looking at periodic returns such as quarterly returns gives cues.
For example, if the return from a large-cap fund in one quarter shows an uptick not in line with the benchmark market index even after accounting for the fund manager’s contribution with active management or alpha, then it may be a cue for you to explore if the manager is taking more risks than what you signed up for. This may include higher exposure to more volatile sectors and segments such as mid- and small-cap stocks or higher tactical trading activities. Or, if a short-fund that is focused on earning accrual income sees volatility in the quarterly return, it may indicate that the fund is moving into long-term securities and the capital gains and losses are causing the volatility. Track short-term returns periodically for triggers to explore the suitability of a fund on risk and return parameters.
You can assess how well a managed portfolio, like a mutual fund, performed in different market scenarios by looking at one-year calendar returns. Tracking investment returns over multiple calendar years will give you an idea of how the portfolio has performed in rising and falling markets. Investors would like portfolios that rise more than the benchmark in rising markets and fall less in declining markets.
Don’t forget to account for costs and taxes, while estimating returns from an investment. That is the actual return you are going to enjoy. Once you know the returns from an investment and its implications, you can use it to make investment decisions.