Why may a person’s return calculation be wrong?

256px-Ertragsgesetzliche_Produktionsfunktion_svgPeople often get the calculation for their investment rate of returns wrong. Most people use the average rate of return which completely ignores the time value of money. The average rate of return may over, or under, state actual returns and are not suitable for comparisons with other investments.

Most investments people have receive money at various periods, and some withdraw money over various periods as well. Those time periods and cash flows should be accounted for properly.

Suffice it to say – doing your own returns calculations is fraught with error. This article on the Modified Dietz method has a good discussion of proper calculations. The links above, in the first paragraph, also lead to good examples and uses.

If you add or withdraw money from investments, then the investment’s return calculation will be different than your personal calculation because, even though you are invested in the exact same thing, e.g., XYZ Mutual Fund, as others, because when you added or subtracted money makes your personal return different than those who simply kept the fund without any changes. In other words … the timing of when money goes in, or comes out, makes a difference because, it depends on what the investment did before and after the addition or subtraction of money and the time periods between.

Also, the combined weighted return of all your investments together results in your personal rate of return; and all the cash flows in and out of those other holdings also change your personal returns of those holdings. This makes the statement I made earlier more relevant: “The average rate of return may over, or under, state actual returns and are not suitable for comparisons with other investments.”

Photo: See page for author [Public domain], via Wikimedia Commons

About Larry Frank, Sr.

Larry R Frank Sr., MBA, CFP®, is an experienced financial advisor and a published author on Retirement Planning Research. Have a financial question? Click Here to Ask Larry

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