Morningstar.com's Interactive Classroom

Course 506
Calculating Your Personal Rate of Return

Introduction

Your fund says it finished the year up 15%. The Morningstar Fund Analyst Report says the same. Yet you only made 10% on the fund for the year.

The fact is, returns depend a lot on how you calculate them. Your actual investment or personal rate of return in a fund may be better—or worse—than you think, because of the timing of your purchases and sales. Knowing your portfolio's actual returns can help you determine if you're on track to meet your investment goals, and whether your funds are living up to your expectations.

Reported Returns versus Personal Rates of Return

The simplest way to calculate return numbers—and the way Morningstar and most other sources do it—is to assume you made a single lump-sum investment at the beginning of the reporting period. So the 15% return on your fund assumes that you bought all of your shares right at the beginning of the year.

Often, however, your personal rate of return will be different. If you bought or sold shares during the period for which a return is being calculated, or if you didn't buy exactly at the period's start, your personal return won't match the formulaic return. Put another way: Your fund's trailing 12-month return doesn't tell you how you've been doing if you invested \$100 each month rather than \$1,200 up front.

You’re on your own when it comes to calculating your personal rate of return. If you choose to enter a Transaction Portfolio in our Portfolio Manager, meaning that you enter the date on which you purchased various securities as well as the price you paid for them, you can see your personal gain or loss in individual funds (and in your entire portfolio) since you made an investment. Or you can enter the dates and prices of any purchases or sales into a financial calculator, or use the internal-rate-of-return function included in spreadsheet software.

How to Do It

Here's what you need to calculate personal returns for a single year:

• Your ending balance from the preceding year (for a single fund or for a portfolio of funds). For the sake of our example, let's say the preceding year's balance is \$2,500.

• Your ending balance from the year for which you're calculating the returns. In our example, we'll use a final balance of \$5,250.

• How much you invested during the year and the months in which you made the investments. In our example, the investments were \$1,000 in May and \$1,500 in November.

Note that the beginning balance and the investments during the year are negative numbers when you're using a financial calculator or spreadsheet. That's because you're trying to figure out the internal return represented by the difference between the \$5,250 you ended up with and the \$5,000 you invested (\$2,500 beginning balance plus two investments during the year of \$1,000 and \$1,500).

If you're using a financial calculator, here's what to do:

1. Make a chart of your monthly cash flows. For a portfolio, pool together the cash flows for all of your funds. Assume that all investments during a month are made at the beginning of that month. Sum your initial balance and any January investment for the first month's entry. Also, determine the value of your fund at the end of the holding period. Locate the cash-flow function on your financial calculator and clear the memory of any old data.

2. As your calculator prompts you, enter cash flows. (Inflows are negative and outflows are positive.) Enter 0 for months with no cash flows and enter your ending balance as the final, positive cash flow.

3. Choose the IRR (internal rate of return—another term for personal rate of return) function on your calculator and compute. The result is your monthly personal rate of return.

4. (1) Divide your monthly IRR by 100. (2) Add 1. (3) Raise the number to the 12th power (12 months in a year). (4) Subtract 1. (5) Multiply by 100 to get the annual percentage.

 Calculating IRR with a Financial Calculator Month Flow CalculatorKey Command January 0 ENTER cash flow -2,500 February 0 ENTER cash flow 0 March 0 ENTER cash flow 0 April 0 ENTER cash flow 0 May 1,000 ENTER cash flow -1,000 June 0 ENTER cash flow 0 July 0 ENTER cash flow 0 August 0 ENTER cash flow 0 September 0 ENTER cash flow 0 October 0 ENTER cash flow 0 November 1,500 ENTER cash flow -1,500 December 0 ENTER cash flow 0 ENTER ending balance 5,250 Monthly IRR 0.5928 Annual IRR 7.35%

With a spreadsheet program such as Excel, enter the months and cash flows as follows:

 January -2500 February 0 March 0 April 0 May -1,000 June 0 July 0 August 0 September 0 October 0 November -1,500 December 0 Ending Balance 5,250

Select the IRR function, and you’ll get the monthly personal rate of return for your portfolio. Follow step four above to calculate the Annual IRR.

What Personal Returns Tell You

Calculating your personal rate of return may not be your top choice for filling your free time on a Saturday afternoon. But doing so not only tells you how you're progressing toward your goals, but it also sheds some light on how well you've been investing.

If your personal returns for an individual investment are significantly lower than those reported by the fund company or shown on Morningstar.com, take a close look at when you've been buying and selling. Maybe you bought hot funds after they had already hit the top, or sold when a fund was bottoming out and therefore missed a subsequent rebound. In that case, a disciplined dollar-cost-averaging program could keep you from sabotaging your results. You'll likely find that making short-term swaps in and out of the market—or between different funds—has hurt you more than it has helped.