Give Your Portfolio Its Annual Checkup

Physician's Money Digest, December31 2004, Volume 11, Issue 24

Now that 2004 is over and you will soon getthe full-year account statements for yourinvestments, you should ask yourself,"How am I doing?" To start with, look atall of your investments in taxable and tax-deferredaccounts as one portfolio and measure its return.Later, you may want to analyze the returns of individualaccounts. Some of your account statements mayalready show these returns, but these are only partialpictures. You need the whole truth.

Including Information

Calculating the actual return of your portfolio is relativelyeasy, provided you kept certain records.Conceptually, if you did not add to or withdraw fromyour portfolio all year, the return on your portfolio is itsyear-end value (eg, $105) minus the year-beginning value(eg, $100) divided by the year-beginning value (eg, 5%).But life is never this simple.

You most likely made contributions and withdrawalsduring the year. Also, you probably incurred some taxesand investment costs. To correctly calculate the return,put together a month-by-month table of all cash flows(ie, movement of money into and out of your portfolio).

On the inflow side, remember to include 401(k) andother contributions that are automatically deducted fromyour paycheck and any employer contributions. Youshould be able to find the other contributions and withdrawalsby looking at various account statements oraccessing the history of your accounts on the Internet.Your checkbook may also be of help. You do not need toinclude in your table any transactions among the accountsin your portfolio. Movement of money from one of thoseaccounts to another is unimportant for this calculation.

For investment costs, only list costs that were significantand not deducted from the accounts directly.Most investment costs are deducted directly from theaccounts. While you should worry about them inother contexts, for your annual return calculation,they are irrelevant because your year-end portfoliovalue already reflects them.

If you had taxable investment income or realizedcapital gains for 2004 on which you paid taxes fromaccounts (eg, your bank account) outside of the portfolioor are going to have to pay taxes at tax time, youshould include those taxes in your table as outflows aswell. You probably won't have exact amounts yet, butreasonable estimates will do.

Calculating the Return

To calculate the return for the year using this data,use a program like Money, Quicken, or Excel. If youdo not know how to use these programs, your financialadvisor, friend, or relative should be able to do sofor you. The technical name for the return calculatedis the internal rate of return, which is the return youshould look at.

If the net of your additions and withdrawals for theyear was small relative to the size of your portfolio, youcan calculate an approximate return without anyone else'shelp. If you netted an addition to the portfolio over theyear, add the amount to the year-beginning balance. If thenet was a withdrawal, add the amount to the year-endbalance. Next, calculate the return as explained earlier.

Judging the Return

This is the difficult part, and it is easy to draw misleadingconclusions. You can't judge the return on yourportfolio by itself; compare it to an appropriate benchmark.Defining the right benchmark for a portfolio isone of the most complex and, to some extent, unanswerablequestions in finance.

However, for now, you can simply estimate theaverage composition of your portfolio for the year (eg,50% stocks, 30% bonds, and 20% money marketfunds) and create a benchmark by applying the sameweights to the 2004 returns on the Vanguard TotalStock Market Index fund (VTSMX), Vanguard TotalBond Market Index fund (VBMFX), and VanguardMoney Market Prime fund (VMMXX).

author of The Only Proven

Road to Investment Success (John Wiley; 2001)

and Financial Modeling Using Excel and VBA

(John Wiley; 2004), currently teaches finance at

the Fordham University Graduate School of

Business and consults with individuals on financial

planning and investment management. He welcomes

questions or comments at chandansen@aol.com.

Chandan Sengupta,