The Dow is down around 34% since mid-May. Or is it? Sometimes, performance is largely in the eye of the beholder.With all of the different ways to measure rates of return, the numbers you read in investment prospectuses and papers might not mean as much as you would think. So, want to know how to measure your investment performance objectively? Read on.
The Problem With Measuring ReturnsIt's hard not to take note of all the news articles that have broken down the trillions of dollars that the country has lost that was right there, on our collective investment account statement, just a few months ago. In 2008 alone (so far), the S&P 500 has taken a 40% dive, and investors throughout the country have seen their investment accounts and 401(k)s deplete at an alarming clip. What kind of returns have you seen this year? According to Morningstar, the average large cap mutual fund had a total return of almost negative 41% this year (not a far cry from the S&P). That means that the price of any given large-cap mutual fund dropped 40% after interest, capital gains, and dividends. Not a pretty picture. Returns are not always as objective as they may seem. The main reason for this is because it's not always clear what a "return" is. Is a return the price appreciation of a stock you own? Is it the value appreciation? Does it take periodic losses into account? With that added attention, you may have noticed that big indices like the S&P 500 and Dow Jones Industrial Average don't always move equally -- at any given moment in the trading day, the Dow could be up, while the S&P could be in the red. But why is that? Aren't the S&P and the Dow supposed to give us an accurate view of what happened overall in the market? Well, one reason is that they don't look at all the same stocks -- the S&P follows an extra 470 of the country's biggest companies. But even if the two followed the same exact companies every day, they wouldn't show the same returns at the close of the trading day.
Here's why: They use different methods to calculate returns (we'll get to those in a minute). And in today's volatile markets, those differences can amount to a pretty big number, so let's take a look at how some of the big indices calculate returns.
Interesting IndicesOne of the oldest market indices in the world is the Dow. And it shows its age... The index is price-weighted, which means that higher priced stocks have more influence over its performance. In other words, let's say that one day the only stocks that change in price are Exxon Mobil ( XOM) ( XOM) and IBM ( IBM) -- both Dow components -- and they move down 35% and up 35% respectively. While it may come as a surprise, the Dow will not end things at 0% for the day. It'll actually be up for the day because IBM (the stock with the higher share price) was up. If you owned $1,000 of each stock, your portfolio wouldn't have seen a gain or loss that day, but the Dow would have. Detractors claim that the Dow is flawed because a stock's share price can skew the index. Imagine what a big movement in a stock like Berkshire Hathaway ( BRK.A) (with a six-figure share price) could do. Hoping to deliver more accurate returns, the folks at Standard & Poor's developed the S&P 500 in 1957. The S&P is a value-weighted index, which means that companies with higher market capitalizations have a bigger effect on the index's overall movement. On a day where only Exxon and IBM's share prices changed, Exxon's giant market value would cause a bigger effect than IBM's equal change. But your $1,000 holdings still haven't changed. Another way to calculate returns is by equally weighting all of the stocks in a portfolio. One example is the Rydex S&P Equal Weight ETF ( RSP), which uses an equal weighting of all stocks in the S&P 500 to calculate returns.
Let's go back to our IBM and Exxon Mobil example. Right now, the daily returns (based on recent trading days) for each stock are -1.12% and +3.31%, respectively. Here's how we would calculate our portfolio's returns under each of these methods: Price-Weighted: Today's Combined Prices minus Yesterday's Combined Prices divided Yesterday's Combined Prices ($149.17 - $149.97) / $149.97 = -0.53% Value-Weighted: (Today's Values - Yesterday's Values) / Yesterday's Values ($459.12B - $455.44B) / $455.14B = +0.81% Equal-Weighted: Exxon's Daily Change + IBM's Daily Change -1.12% + 3.31% = +2.19% That's right, the way returns are calculated can mean the difference between gains and losses on a given day. As you can see, over time there can be a pretty material difference in returns depending on how they're calculated.
Fat Pitch Financials offers a tutorial on calculating your returns, as well as useful spreadsheets to help you calculate them for your holdings. Geometric Average Return. The most accurate way to look at your performance is by calculating this useful metric. TheStreet.com's Portfolio Yield Calculator offers a quick way to calculate the returns on your portfolio.