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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.

Calculating Your Personal Return

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

Calculator
Key
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.

Quiz 506
There is only one correct answer to each question.

1 Why might your personal returns in a fund not match the fund's reported returns?
a. Fund companies don't take expenses into account when reporting returns.
b. You didn't invest in the fund at the start of the period that the reported returns cover.
c. Fund companies determine annualized returns by averaging the most recent month’s gain over a 12-month period.
2 Why does your personal rate of return matter?
a. Because its probably lower than you think.
b. Because its probably higher than you think.
c. Because it helps you to evaluate how your portfolio and individual funds are performing, and also helps you assess your timing as an investor.
3 Where can you always find your personal rate of return for a fund?
a. Your account statement.
b. The shareholder report.
c. Neither.
4 When calculating your personal returns on a spreadsheet or financial calculator, why do you have to enter negative numbers for your contributions?
a. You don't; you enter positive numbers.
b. Because you're trying to figure out the internal return represented by the difference between your final balance and your beginning balance plus the money you've invested.
c. Because until you redeem your fund shares, those investments don't have real value.
5 If your personal rates of return for a fund are significantly lower than the reported return over the same period:
a. You're in the wrong fund for you.
b. You’re better off avoiding volatile stock funds and instead focusing on those with limited risk, such as money market funds.
c. You may be buying and selling at inopportune times. Stop trading so much and implement a dollar-cost averaging strategy, investing smaller sums at regular intervals!
To take the quiz and win credits toward Morningstar Rewards go to
the quiz page.
Copyright 2006 Morningstar, Inc. All rights reserved.
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