This is a post for Capital Mind Premium subscribers.
Calculating portfolio returns can be complex, and is by far the most important thing for you – it’s all that matters. It doesn’t matter that one stock did 40% or that another stock did 26%, while yet another one fell 2%. The point is about how much money you made, period.
The other factor to consider is staggered investments. We almost never buy at the same time. We buy over time, and then sell over time. What, then, is the way to calculate portfolio level returns?
It’s simple once we understand the concepts. Think of yourself as a mutual fund, in a way. You’re the manager. You charge no management fee. The only metric that matters now is – how much have your assets grown (AUM growth) and how much of that growth can be attributed to your investment activities.
The “Exposure” Calculations
Let’s say we started buying in December, with the Capital Mind Portfolio, and went through in Jan with the other picks suggested.
At the end of January, how would we evaluate our performance? Firstly this is not enough information.
Need a Transaction Table
To get a handle of returns, you need to buy quantities of the above stocks. If you had put an equal amount in each stock, your transactions may look like this:
Now, this means that we put in Rs. 50,042 in December. The rest of the money was put in January. We allocated a near equal Rs. 50,000 per stock.
How can we figure out what returns we have got, on 31 Jan? Let’s first calculate the value of the portfolio on 18 Jan.
But you might say – I invested Rs. 200,178, and now my portfolio value is Rs. 201,077. The profit is Rs. 899. That, on my investment, is 0.45%. Is that my return?
The answer is: No, because your investments were staggered at different times and with different amounts each time. The correct way is:
Do the Cash Flow XIRR
Then, let’s prepare a “Cash Flow” table. Whenever you invest into a stock, cash flows “out”, so you term that amount negative. When you sell stock, you receive cash, which is a positive amount.
So what you do on 31 Jan is:
- Assume you sell all the stock at the current market value
- The amount you receive is positive cash flow. Which means your cash flow items will look like:
Now you can use the XIRR formula in excel to figure out your returns. XIRR takes a bunch of values and a bunch of dates. Pass those and you see the annualized returns.
The XIRR formula for the above cash flow, gives an annualized return of 38.3%.
To see this in detail, check out the first webinar that Capital Mind Premium had conducted where we speak of Investment Returns in Excel.
Note: XIRR over small terms is not useful since you can’t easily replicate this performance (if it’s very large). So you should take returns over longer periods (at least one year).
Adding More Transactions
Let’s say that on 3 Feb we added one more stock (Kaveri Seeds) and sold about all of our holding of Alembic Pharma on 10 Feb at 240. Where will we be on 28 Feb?
The Portfolio no longer has Alembic and you’ll see the market value has hardly changed! Is this bad?
Answer: Again, no. You need to work this again with the cash flow perspective. Here’s the cash flow:
The return is actually better than earlier! 43% now versus 38% earlier.
The cash flow shows it right. You’ll notice that what you sold went for more than what you invested, which has added to your return!
You could do this with any layer of investment – stocks, mutual funds and so on. But we have to get even more real.
Getting More Realistic: Cash Entries
While this kind of accounting makes sense, we don’t generally look at investing in stocks alone. We have “investible cash”. This cash needs to be invested in stocks, or placed with mutual funds or simply stays as cash.
So what you would do is to simply have another entry, such as “Cash”. Let’s assume you kept Rs. 500,000 as cash money in a fixed deposit earning 8%, and used part of that money to pay for the transactions you have made. (Or you could buy a liquid mutual fund).
What you do is to record the entire amount as a single cash flow (Rs. 500000) and at every measurement, assume you sell all shares and take whatever cash is left, and measure the returns using the same XIRR formula.
The idea is that the cash is distributed to stocks. Each time you do that, your cash value changes. You record as interest the amount of money earned during the period. So between 1 December 2013 and 14 December 2013, you had Rs. 500,000 as cash. You then bought Rs. 50,042 worth shares.
The amount of interest you have earned in those 14 days is: 14days / 365 x (8%) x (500,000) = Rs. 1,425.
That is then maintained separately. You do similar calculations when new transactions are done.
Finally, at the end of February, let’s value the portfolio. We know the valuation at the end which is:
So the total portfolio value = the value of your stocks plus the cash.
Therefore the XIRR is like this:
Here’s where you’ll notice that suddenly your return went down considerably! From 43% in the first method to just 12.3%.
That’s because you didn’t deploy your cash entirely in one transaction. You only deployed a part of it. The cash return of 8% reduced your overall portfolio return.
Accounting for Cash Additions
Many of us aren’t traders and receive external cash flows, like salaries, gifts or other pieces of income. This should add to our savings, and be deployed in stocks or mutual funds or anything else.
When you get more cash to invest, you will
- Create a cash transaction to augment your cash
- Put an entry in the cash flow table appropriately.
For example if we did the above transaction with:
- Rs. 100,000 cash on December 1, 2013 and
- added another 100,000 on Jan 1, 2014, and
- added ]another 100,000 on Feb 1, 2014
Here’s how things would look:
The XIRR is really all that matters. You can put in and take out cash as you like, and it doesn’t even matter if it’s done at random dates with no order in it.
You should technically also deduct taxes from the cash, any fees paid (demat charges, brokerage) and any other costs.
We hope this has helped clear your understanding of how returns should be calculated.
In Capital Mind Premium we are only talking about stocks we buy or sell. We aren’t actually giving you portfolio level details of how much, what kind of cash component we have, etc. This is unfortunately too complex for us to explain or mention at every juncture, and our weightages to certain stocks may be different. While it provides an incomplete picture of returns, the point of the Capital Mind Portfolio is to learn how we do our investing, rather than to provide something everyone can follow blindly. We hope this post has helped you understand how to evaluate your own returns.
Another note: Mutual Funds embed all these calculations in their NAV. So their NAV is essentially their Total value of their holdings + cash – (obligations) – (fees). Insurance companies however tend to deduct units for some fees instead of putting it in the NAV, so every month, your total holding quantities change, and it makes return calculation entirely difficult.
Please do let us know if you have any questions on the subscriber-only Google group, or mail us at firstname.lastname@example.org.
Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion.
Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.