From time to time, we are asked a question like “what return should I be getting on my investments?”
Well, that depends. Every individual has a different set of needs, goals, and cash flows. Figuring out an investment return is therefore a highly individualized process. If you are invested in a diversified, low-cost portfolio, your returns should track those of the markets you are invested in for any given time period.
In evaluating your own investment return, it is also important to understand the difference between time-weighted returns and money weighted returns. The time-weighted return is how the portfolio did over a specific time period with no changes such as funds being contributed or withdrawn. While this isn’t necessarily a bad way to evaluate an asset allocation, it frequently has little to do with an individual investor’s actual return.
The money-weighted return (also known as internal rate of return) on the other hand takes into account the timing and amount of cash flows into and out of the portfolio during the time period in question. Thus, it is usually a better measure of your actual returns than the time-weighted return.
For example, let’s take a portfolio that appreciates 20% in year one and then drops 20% in year two. If you started with $100, then you had $120 at the end of year one and $96 at the end of year two. In this case, your time-weighted return over the two-year period is negative.
If, however, you withdrew $50 cash at the end of the first year (leaving $70), then only the $70 would be exposed to the 20% drop in year two---leaving you with $56 in the portfolio and $50 in cash. Your money-weighted return for the two-year period is positive.
Same portfolio, same time period, but different cash flows. This means different returns. This is an important concept to understand.
As for us, we don’t focus on “returns.” We keep broadly diversified, low-cost portfolios that are individually designed to fit the long-term goals and risk tolerance of each of our clients. We periodically rebalance our portfolios with existing or new investments. Every now and then, when a given asset class looks either very expensive or very inexpensive, we act accordingly---then we wait. We’d suggest you do the same.