On the Money: Measuring investment performance

Most investors do not know how their portfolios have performed. Partly to blame is the fact that brokerage statements generally do not show investment performance. The basic definition of investment performance is the total sum of interest, dividends, realized and unrealized gains or losses. Since mutual funds represent a popular way to invest, let’s look at how to evaluate those returns.

There are differences in the returns earned by the average investor in a mutual fund and the returns reported by the investment manager of the fund. The average investor may have invested at different times in the fund. The investor’s return is a flow-weighted return. This return is also called “dollar weighted” and represents the investor’s internal rate of return. 

The skill of the fund manager is measured in a different method, called “time-weighted” rate of return. This measures the manager’s abilities and eliminates the influence of cash flows (which the manager has no control over). The public numbers that a mutual fund reports are time-weighted since they represent the most appropriate measure of the manager’s abilities.

The reason why an investor’s return can be different than what the fund reports is due to cash flows.

Many investors employ a disciplined method of investing called “dollar cost averaging,” whereby you invest a fixed dollar amount in a fund at regular intervals. This method is successful in that when the share prices are low, the fixed dollar amount invested purchases more units. When share prices are high, it purchases fewer units.

On the other hand, many investors do not adhere to the discipline of dollar cost averaging. They allow emotions to drive their decisions. A study done in July 2008 by Dalbar, Inc. and Lipper computed the comparison between the “average stock fund return” and the “average stock fund investor.” The results are shocking. From 1988 to 2007 the average stock fund returned 11.6 percent per year. The average investor results, using cash flow reports, showed that the average stock fund investor achieved only 4.5 percent return per year. The emotions of investing are to blame for causing such a dramatic investor penalty – 7.1 percent per year! It represents behavior such as chasing hot performance and trying to time the market. The investor who maintained a buy and hold approach would achieve returns that mimic the “average fund return,” which in this study would have been 11.6 percent annually for a 20-year period. 

Investors should be aware of how buying and selling of investments can impact their final results.

Kathy Lakritz is an investment manager with Schenck Investment Solutions LLC.


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