Most people don’t follow their investments. They tend to just buy whatever their advisor at the bank says or use a passive investment portfolio like the popular Canadian Couch Potato portfolios. When it comes time to review, which might happen once year, investors wonder why the gains are so small when the market has done so well.
This is a common question that people ask me. “I’ve invested for a year but I only have a 2% gain. What gives?” It almost seems like many are expecting gains to be extremely large, but the numbers are a disappointment. “What’s the purpose of investing and taking risks when gains are only 2%? Couldn’t a high interest savings account be better since the principal is guaranteed?”
There are many reasons why a portfolio could be underperforming. Perhaps there are high fees that are charged by your advisor, or the bank is taking a service charge off your account, but many times the low gains comes down to something else. Bad software. Many computerized systems used by the banks and brokerage firms don’t handle dividend reinvestment well nor represent gains well when additional capital is added to the investment portfolio. The result is the appearance that an investment portfolio is doing much worse than it really is.
First off when a brokerage creates a fancy interface with charts and graphs for users to track their investments, one can consider this a bonus. A brokerage gets no money from creating a fancy financial investment tool. That’s not how they make money. That’s why there is very little effort put forth by the brokerages to make a really good software program for investors to use. The bare minimum is enough.
The issue with these systems, especially if you are doing a passive investment portfolio with ETFs, is that it doesn’t calculate annual gains very well when you reinvest your dividends. Think this example:
- You start the year investing in an index ETF for the TSX. You put $10,000 in, buying 500 shares at $20 and the fund pays a 2.7% dividend which is reinvested.
- Over the period of a year, additional stock is purchased because of the quarterly dividend payment. That could be 3 additional units per quarter or 12 more shares a year.
- At the end of the year you now hold 512 shares valued at $10,800.
- You login to the bank to review and you realize that the bank says you’re up 5.4%
Let’s review some of this math right here. Anyone that knows basic math will know something is amiss. If you invested $10,000 at the beginning of the year and the portfolio is now worth $10,800, how the heck is it up 5.4%? Even the kids on “Are You Smarter Than A 5th Grader?” would know something is wrong.
The reason why 5.4% seems wrong is because the bank doesn’t account for dividends in the gains. If the dividends are reinvested, many investment platforms assume you bought these with extra money. Therefore any gains from dividends are calculated as part of the original capital. The bank does this:
- The bank will assume that 512 shares are purchased at an average price around $20.
- The original average total cost of $10,240 is subtracted from the current value of $10,800 to get a gain of $560.
- $560 is divided by $10,240 to get a gain of 5.4%
What should all these systems actually do?
- Recognize that the original investment has gone up around 5.3%, or roughly $530 in capital gains
- Reinvestment of dividends is actually a return on the original principal and thus adds 2.7%
- The total gain for the year is $800. Or simply 5.3% + 2.7% = 8%
Regardless of gains or losses, the software systems employed by online brokerages and even robo-investors don’t do calculations properly. That’s why gains and losses are always reported incorrectly and you feel ever so pissed off that your investments are doing poorly.
Another very deceiving calculation that many software systems fail to correct for is the addition of capital to the investment portfolio. This can really throw the calculation for gains off because it ends up diluting the percentage gains for the year. What do I mean with that?
See many people don’t just throw a pile of money into their investments and let it sit forever. That’s not what building an investment portfolio is about. Many people will either gradually start investing, or invest periodically when they’ve saved enough money to make a contribution. When these contributions are added, it throws off all the calculations in the system. For instance:
- At the beginning of the year 100 shares of the TSX was bought at $20 a share. A total amount of $2,000 was invested.
- During the year the TSX gained 10% and now the value of the original investment is $2,200
- However, during the middle of the year another 500 shares were bought at $21.50 a share for a total amount of $10,750
- At the end of the year, those extra 500 shares only went up $0.50 and are now worth $11,000
- The year end total for the entire portfolio is now $13,2000
When money is added in the middle of the year, it could have a big impact on the gains that were made when reviewing at the end of the year. Despite the TSX being up 10% for the year, the software might show that you’ve only gained 3.53%. What gives?! Why am I being shafted yet again?
OK! Hold your horses. This isn’t actually a wrong calculation, but a total misunderstanding from our part. Yes the market did go up 10%. No you didn’t lose out on any gains. The fact that the software shows 3.53% is because the extra money that was added in the middle of the year didn’t grow by 10%. It was added much later in the calendar year and didn’t get the same benefit as investing earlier. However, since the gains were smaller and the amount invested was 5 times bigger than the original amount, it ended up diluting the yearly gains. So really you were not duped of any returns, nor should you be fretting that your investments are doing poorly. It’s all just the interpretation of the number.
Do It Yourself
It’s hard to get an accurate representation of your returns, but sometimes I like to do it myself because I can get a better estimation of how well my money is working for me. One way to do it using Excel or Google Sheets to do it using the XIRR function. I’ve written a previous blog post on how this calculation works.
The difference when using this alternative do-it-yourself method is that you only concern yourself with cash inflows and outflows from your portfolio. This method of calculating returns is essentially using a discounted cash flow method of using money added and subtracted. You can definitely learn more by Googling “internal rate of return” if you’re interested in financial math (I honestly know you’re not). This method makes life easier because keeping track of when you put money in and when you take money out is much easier than trying to figure out how many shares your dividends buy.
So next time you review your portfolio ask yourself just these questions. Is it matching the market returns? Did you dilute your shares along the way? Are you enrolled in a dividend re-investment plan? Make sure you fully understand why your investment portfolio is performing the way it is before screaming about theft. You can save yourself some embarrassment.