2million - My Journey to Financial Freedom

A Personal Finance Blog      ANNOUNCEMENT:2million has moved to www.2millionblog.com.     

Wednesday, February 22, 2006

Taking Assessment of My Portfolio Returns, Part 1: The Bottom Line

It is finally time for me to sift through all the financial data I have for 2005 and begin to understand how my portfolio worked for me in 2005. My net worth went from $157,340 on 12/31/2004 to $206,990 on 12/31/2005 - this should be pretty easy, right?

No way. I have been scratching my head trying to understand how I should handle reinvested dividends, additional investments throughout the calendar year, and how to treat my rental house. I have decided to start by simplifying this analysis to just try to get an understanding of how my investments faired - therefore I might not yet be able to easy demonstrate what my TRUE rate of return for each investment was, but I should be able to benchmark the total return for my entire portfolio.

This analysis would be much easier if I wasn't saving so much money! One of my problems is that in most of my investment accounts I have added additional investments over the course of the year. This is a problem when it comes to calculating a TRUE rate of return because you then need to factor in the rate of return for all these additional small investments over the course of the year.

Assumptions for Assessing Investment Returns
Let me begin by making some assumptions about how I want to treat various transactions on my balance sheet:
-my rental house is an investment so I will treat the mortgage principal paydown as investment return
-Any principal payments to my mortgage for my primary residence will be treated as retained earning to adjust for net worth change calculation
-car principal payment will be treated as retained earnings to adjust for net worth calculations
-401k company matching will be treated as investment returns
-I am going to ignore taxes on investment returns such as dividends and interest. Most of my dividends are immediately reinvested in more stock and at the end of the year I have to pay tax out of pocket for those dividends. Accounting for this would be too painful and I don't think it would impact my investment returns.
-I'm going to ignore the return on any investments made over the course of the year for now. This may result in my calculated return being slightly higher than my TRUE return.

Step 1: Formula for Entire Portfolio Return
To start this analysis I thought I could get a rough idea how I faired by using this simple formula:
[12/31/2005 Net Worth] - [Net Worth 12/31/2004] - [2005 Retained Earnings] = [2005 Investment Returns].

Since I knew my 2004 and 2005 net worths, all I would need to do was calculate what adjustments (retained earnings) where made in 2005 as a result of earned income and this would give me a rough idea of what my 2005 investment returns were (ofcourse this is not completely accurate because of many additional sources of income that don't classify as savings or investment returns such as rebates, bonus money, gifts, etc).

Step 2: Plug in 12/31/2004 Net Worth and 12/31/2005 Net Worth
According to my records my net worth on 12/31/2004 was $157,340 and my net worth on 12/31/2005 was $206,990. All I need to do is plug these into the formula.

[12/31/2005 Net Worth] - [Net Worth 12/31/2004] - [2005 Retained Earnings] = [2005 Investment Returns]
[$206,990] - [$157,340 ] - [2005 Retained Earnings] = [2005 Investment Returns]

Step 3. Figure out what I retained from my earned income
So with that I needed to calculated what earnings I retained in 2005. This basically means I need to figure out what part of my earning went to boosting my net worth.

I start by finding out what my net cash change is. I total the change in cash I have in savings and checking accounts and subtract out any CC balance changes:

Net Cash Change in 2005

 

Change in Checking Balance

$ (174.85)

Change in Savings Balance

$ 20,022.29

Change in Revolving CC Balance

$ (1,309.03)

Change in 0% APR Balance

$ (10,346.00)

Total

$ 8,192.41



Then I need to add in retirement account contributions and investment account contributions:

Retirement Accounts Deposits

 

401k Contributions

$ 17,750.40

Roth IRA Contributions

$ 3,550.00

Total

$ 21,300.40



*Note: My 401k contributions do not include the company match (I'm am going to treat the match as an investment return in this analysis). They do include an additional $3,750.40 in after-tax contributions that the IBM 401k plan allows employees to make. I'll talk more about this feature at a later time.

Investment Account Deposits

 

Etrade

$ 2,000.00

IBM ESPP

$ 7,371.58

Pfizer DRIP

$ 7,400.00

Merck DRIP

$ 2,500.00

CMS DRIP

$ 25.00

Duke DRIP

$ 250.00

Total

$ 19,546.58



I also need to include principal payments I made on my car loan and mortgage since these were items that boosted my net worth but had nothing to do with investment returns:

Loan Principal Payments

 

Car Loan

$ 2,700.00

Mortgage Principal*

$ 1,018.60

Total

$ 3,718.60



*Note:Only includes principal payments when house was my primary residence, after rental conversion these payments are treated as investment returns.

Now I need to make some adjustments and back out some items included in these totals. I have 2 stock holdings (IBM & Bellsouth) where I elect to take the cash dividend and deposit them into my cash accounts. I need to back these out of my retained earning number because these are really investment returns. I also need to back out any interest I accumulated on my cash accounts. My net expenses exceeded my rental income so I don't think I need to make any adjustments regarding the income received from this activity.

Back Out These Cash Deposits

 

Bellsouth Dividends

$ 166.38

IBM Dividends

$ 251.37

Rental profit

$ -

Savings Accounts Interest

$ 783.99

Total

$ 1,201.74



Finally I need to catch everything I missed. I did receive a rental deposit in 2005 that is being treated as cash so I need to back that out of my cash. I also made an adjustment in December for an expected increase in tax liability, which I need to remove from my cash total.

Misc Liabilities

 

Tax Liability

$ 3,000.00

Rental Deposits

$ 1,000.00

Total

$ 4,000.00



Ok now lets total this all up:

2005 Retained Earnings

 

Net Cash Change

$ 8,192.41

Retirement Accounts Deposits

$ 21,300.40

Investment Account Deposits

$ 19,546.58

Loan Principal Payments

$ 3,718.60

Back Out These Cash Deposits

$ (1,201.74)

Misc Liabilities

$ (4,000.00)

Total

$ 47,556.25



After crunching the numbers I established I retained $47,556.25 of my earned income based on the assumptions I detailed earlier.

Step 4: Compute 2005 Investment Return
Now we just plug the retained earnings in and compute what my total return was:

[$206,990] - [$157,340] - [$47,556] = [2005 Investment Return]

Wow this is going to be ugly......

[$206,990] - [$157,340] - [$47,556] = $2,094

Ugh! I am shocked, confused, and embarrassed. I started the year with $157,340 and somehow managed to only gain $2,094?? How can I, a person who is at least semi-financially intelligent be making a 1% return on my money?

If I had stuck my money under my mattress I might have come out further ahead than I did. I'm at a loss for words - I had expected this to be closer to 4-6% (even higher if you didn't include the equity in my house).

In Part 2 of this series, I will take a stab at figuring out what happened to my portfolio.

23 Comments:

  • How could you only make 1% if you actually gained money?

    By Blogger pyroracing85, at 2:06 PM  

  • pyro - not sure I am following you, according to this breakdown my net worth of $157k netted me (in investment gains/returns) only $2k (or ~1% return) for 2005.

    By Blogger 2million, at 2:19 PM  

  • I too have struggled with how to find an appropriate way to estimate the perfomance of my investments. The best that I have been able to come up with is the following method.

    Use this for your entire portfolio, or segments of your portfolio (i.e. 401k or Etrade account)

    B = beginning balance
    E = ending balance
    C = contibutions during period

    Return = (E - .5C) / (B + .5C)

    example: You start the period with $1000, add $200 during the period, and end up with $1300, the Return = 1.09 = 9%

    Because money that you contribute during the period is also making/losing money, the formula assumes that half of your contribution was put in at the beginning of the period, and the other half at the end.

    The smaller the time frame of your period, the more of an accurate answer you'll get. (i.e. a month is better than a year)

    This is the most appropriate way I've been able to come up with, as it gives me performance number that is "close enough" with the least amount of work....

    By Blogger bored, at 2:27 PM  

  • I use your method. 2005 was not a good year for stock market. You should do better this year.

    By Anonymous Anonymous, at 3:57 PM  

  • I am curious to know how you managed to save $17500 in your 401(k) when you say you did not include your employers match in this amount? The IRS limit for 2005 was $14000.

    By Anonymous Anonymous, at 4:00 PM  

  • I agree on the 401K overfunding.

    Are you going to max the ROTH?

    By Anonymous Anonymous, at 4:33 PM  

  • Explanation on the 401k Overfunding: IBM's 401k plan allows you to place additional after-tax contributions (up to 10% of your salary or something) into your 401k plan to take advantage of their lower expense ratios on mututal funds. I was making contributions to it earlier in the year, but decided it wasn't the best place to put my money since there were no tax advantages and the profits would be taxed at ordinary income rates. Ill post more details on this IBM 401k plan feature in the future.

    Yes I do plan to max out my Roth IRA contributions.

    By Blogger 2million, at 4:51 PM  

  • Good catch on the 401k overfunding - I should have explained that.

    By Blogger 2million, at 4:52 PM  

  • wow you could of done better in like a money market account or something like your savings accounts

    By Blogger pyroracing85, at 7:50 PM  

  • I use the same formulae given by bored: return for period = (E-B-C)/(B+0.5C), which is known as the midpoint Dietz method.

    This is an approximation of time weighted rate of return which you can chain link to get the cumulative return for multiple periods.

    I discussed this in my newly started investing blog. Thanks for addressing this important point. Lack of this calculation is the one weakness shared by most PF blogs. The increase in networth is largely driven by savings when the base amount is small, but as the net worth increases, investment return grows in importance. As such, most net worth growth rates of prodigious savers cannot be maintained for very long.

    By Blogger ML, at 11:22 PM  

  • How much money are you making of those 0% balance transfer act?
    Let's assume that you borrowed 30k and you get to earn 4%. Thus you make 1.2k for the entire year. Is it hurting your credit score since are making the minimum payment per month?

    By Anonymous Anonymous, at 1:58 AM  

  • That's scary. Banks are starting to give 5% interest.

    By Anonymous Anonymous, at 3:12 AM  

  • Yes it is scary, but keep in mind its my entire portfolio including my house, my cash, etc. - Im working on the next part in the series and I think youll quickly see why I had such a poor overall rate of return.

    By Blogger 2million, at 3:02 PM  

  • bored & ml,
    Good idea on the formula - At one point I had considered using something similar but ending up going with the formula I described just to keep it simple. I think I will follow up later on with the same numbers using the "midpoint Dietz method" (didn't know what is was called till now) as both of you mentioned just to see what the difference between the 2 rates of return would be.

    By Blogger 2million, at 3:08 PM  

  • good stuff 2million. i like reading your blog. I linked into yours here:

    http://finnews.blogspot.com/2006/02/good-financial-blogs.html

    By Blogger changpeng05, at 9:21 AM  

  • I'm having a similar problem. i get quarterly statement from my 401k.

    apparently i made
    -1.7%
    7%
    2.7%
    4.3%
    in each quarter. however I have no clue how much I made on an annualized basis[and i made biweekly contributions] so i can't really calculate easily. and no one at morgan stanley [who handle the 401k] will tell me either.

    while i'm happy i beat all the averages heftily[although the dollar amounts aren't very impressive] I'd still like to figure out how much i made on a yearlly basis

    By Blogger Empty Spaces Inc., at 9:27 PM  

  • I use Quicken to accurately track investment returns. Once it's set up it doesn't take much time to update with transactions each month. Most brokers/funds can download transactions into Quicken.

    By Anonymous Anonymous, at 12:20 PM  

  • I use MS Money to track my investment returns - I think I will also follow up with a comparision of my estimated returns with what MS Money calculates. However, I don't think MS Money lets you calculate a total return on your net worth. It only lets you looks at individual investments or insetment accounts.

    By Blogger 2million, at 2:42 PM  

  • 2million, nice job on the blog. Your lack of any significant returns are attributed to IBM stock essentially running in place for a year and the market in general not doing much. Having hit the 2M mark myself with much the same numbers that you are working with (I'm a fellow IBMer). I can tell you that you'll make your numbers with one simple thing going for you, your youth. Have you read "Your Money or Your Life" ? It is a great book to inspire you to keep saving.

    In the meantime, don't get too obsessive on your annual return. Your aggressive saving and continued avoidance of debt will overcome mediocre investment years like last year. Also, I'm sure this is becoming obvious, but you really can't do 2005 over anyhow. Don't focus on it.

    Keep dollar cost averaging, enjoy your friends, tell your parents you love them, and the rest will take care of itself. Trust me.

    By Anonymous Anonymous, at 12:50 AM  

  • Hmm...if you really only earned 1% on your money you're hurting big time. You could have quadrupled that by just sticking it in ING...in fact, if that's all you really earned then you really lost money due to inflation.

    Hopefully, that's not the case.

    By Anonymous Tim, at 11:28 PM  

  • By the way, my portfolio increased 15.4% last year (counting dividend reinvestment). I'll be posting my portfolio up on my site soon.

    By Anonymous Tim, at 11:30 PM  

  • Missing elements from return:

    In pondering your calculations, it struck me that you might reconsider one of your assumptions.
    You should consider adding back in the appreciation on your rental property. For that matter you might even consider adding back in the appreciation of your house - as each is part of your net worth.
    I've found that Zillow www.zillow.com is very helpful in gauging real estate appreciation / valuation.
    Now I understand that incorporating RE appreciation can be considered qutie subjective, but in the end it will be sold and there will be a profit or loss.

    I believe certain other online websites provide average rates of appreciation for specific towns/cities - that might also provide a thumbnail. Of course hiring an appraiser or asking a realtor for a market survey if you'd consider selling might also help.

    BTW, I vote using Quicken to make life easy. However, I've found that Quicken's proclivity toward creating placeholders can be slightly problematic - has anyone else had a problem with this?

    regards,
    n

    By Blogger makingourway, at 2:27 AM  

  • I've struggled with calculating an annual return also. The proper way is to discount the additions and subtractions to their present value. This is a method that takes into account additions and subtractions and uses the Excel 'Solver' function to calculate a annualized yield.

    1) The Present Value = $/(1+rate)^(date-beginning_date).

    2) The beginning $$ value is not discounted.

    3) The ending $$ value is entered as a negative value.

    Pick a worksheet cell and enter guess an initial rate (i usually start with 0.001)

    Use excel 'Solver' functionality to solve for "the rate for which the sum of PV = 0.00." This is the daily rate.

    Raise the daily rate to the power of 365 and subtract 1, and you have the annual rate. i.e. (rate^365)-1. Format as a percentage.

    A B C D
    2
    3 Date +/- PV
    4
    5 1/1/2005 $10,000.00 10,000.00
    6 2/1/2005 $1,000.00 994.67
    7 3/1/2005 $1,000.00 989.89
    8 4/1/2005 $1,000.00 984.61
    9 5/1/2005 $1,000.00 979.54
    10 6/1/2005 $1,000.00 974.32
    11 7/1/2005 $1,000.00 969.29
    12 8/1/2005 $1,000.00 964.13
    13 9/1/2005 $1,000.00 958.99
    14 10/1/2005 $1,000.00 954.05
    15 11/1/2005 $1,000.00 948.97
    16 12/1/2005 $1,000.00 944.07
    17 12/31/2005 ($22,000.00) (20,662.53)
    18
    19 0.00
    20
    21 Daily Rtn= 0.000172325
    22
    23
    24 Annual Rtn= 6.49%

    By Blogger Flucktuated, at 5:03 PM  

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