Measuring a security’s performance is a key part of investing. You’ll want to understand how your portfolio is doing and be able to identify your best and worst investments based on their returns. Depending on the security, there may be more than one useful way to measure performance.
Here are the common measures covered in this chapter:
Not all returns are equally impressive. A 10% return could be excellent or disappointing depending on how much risk you took to earn it. For example, a 10% return on a Treasury bill would be extraordinary given its low risk, while a 10% return on a high-risk hedge fund might be considered underperformance. That’s why some investors adjust returns for risk - to see whether they’re getting enough return for the risk they’re taking.
American economist William Sharpe developed a method for measuring risk-adjusted return in 1966. Now known as the Sharpe ratio, it measures return relative to risk:
As discussed in the discounted cash flow chapter, the risk-free rate of return is the 91-day Treasury bill rate. Standard deviation measures how much a security’s returns vary around its average return. Higher standard deviation means more volatility, and therefore more risk. Some investors describe standard deviation as a measure of “pure risk” (as opposed to beta, which measures volatility relative to the market).
The numerator (the top of the fraction) is the security or portfolio’s risk premium:
This represents the extra return earned for taking risk beyond a risk-free investment.
Interpreting the Sharpe ratio is straightforward:
It’s unlikely you’ll be asked to calculate a Sharpe ratio on the exam, but you may see questions about what the components mean or what the ratio is used for.
Investors in mutual funds commonly use two different return measures when evaluating performance. One is time-weighted return, which measures performance over specific time periods while assuming a buy and hold strategy.
A buy-and-hold strategy means you buy the investment and hold it for the entire period, with no additional purchases or sales during that time.
You can usually find multiple time-weighted returns when researching a mutual fund. For example, on Morningstar, the JP Morgan Large Cap Growth Fund (and most other funds) shows returns for many time horizons under “Trailing Returns,” such as 1-month, 3-month, YTD, 1-year, 3-year, 5-year, 10-year, and since inception.
These are time-weighted returns because they assume:
For example, a 3-year return assumes the investment was made three years ago, with no additional purchases or sales during that time.
Time-weighted returns are especially useful for evaluating a mutual fund manager’s performance. Mutual funds are managed by a team of professionals, typically led by a fund manager. Some managers remain in place for long periods because they consistently perform well. For example, Will Danoff has managed Fidelity’s Contrafund since 1990. Other managers may be replaced after only a few years due to underperformance.
Time-weighted return helps isolate the fund’s performance from the investor’s timing decisions. For example, if an investor buys on a day the market is up sharply and sells on a day the market drops sharply, a loss may reflect poor timing rather than poor fund management.
Dollar-weighted return measures a mutual fund investor’s personal return based on both:
Unlike time-weighted return, dollar-weighted return is affected by when cash flows occur. If an investor buys more shares when the NAV is low or sells when the NAV is high, their dollar-weighted return may be higher than the fund’s time-weighted return over the same period (and vice versa).
Total return measures an investment’s overall gain or loss as a percentage of its original cost. It captures all the ways an investor can earn (or lose) money on a security:
Preferred stocks and some common stocks pay cash dividends. Debt securities pay interest.
Any security can have a capital gain or loss:
Total return combines all gains and losses and compares them to the original cost:
Although calculations are relatively limited on the Series 66, total return is a common one to see. The following video shows how to approach a total return question:
Now, try one on your own:
An investor purchases 100 shares of stock at $50 per share. The investor receives two quarterly dividends of $1 per share after holding the security for six months, then sells the security for $55 per share. What is the total return?
Can you figure it out?
Answer = 14%
Let’s establish the total return formula:
You can calculate total return using total dollars or on a per-share basis. Either works. For simplicity, we’ll use a per-share approach.
Total gain per share = $2 + $5 = $7.
Original cost per share = $50.
Holding period return is the rate of return earned over a specified time period. In other words, it’s the total return for the period you held the investment.
In the example above, the investor held the stock for six months, and the holding period return over that six-month period is 14%.
An annualized return expresses a return as an annual rate.
Using the same example:
An investor purchases 100 shares of stock at $50 per share. The investor receives two quarterly dividends of $1 per share after holding the security for six months, then sells the security for $55 per share. What is the annualized return?
We already found the total return over six months was 14%. Since there are two six-month periods in a year, the annualized return is 28%.
For holding periods less than one year, annualize by multiplying the total return by the number of those periods in a year:
For holding periods longer than one year, annualize by dividing the total return by the number of years:
The inflation-adjusted return, also called the real rate of return, is the total return minus the inflation rate. In the U.S., inflation is commonly measured by the consumer price index (CPI), which tracks price changes across a basket of goods and services.
As discussed in the fixed income unit, inflation is especially harmful to securities with fixed rates of return because rising prices reduce purchasing power.
To remove the effect of inflation from a return, use:
Try this practice question:
An investor buys a $1,000 par, 5% bond at 94 in the market. After holding the bond for exactly one year, the investor sells the bond at 97. Assuming CPI is reported at 4% for the year, what is the real rate of return?
Can you figure it out?
Answer = 4.5%
First, find total return:
*Both 94 and 97 are percentage of par quotes. 94% of par ($1,000) is $940, while 97% of par ($1,000) is $970. If you need a refresher on this topic, follow this link to revisit the chapter it was covered in.
Now calculate total return:
Now subtract inflation to get the real rate of return:
After-tax return is total return after accounting for taxes. This can get tricky because different types of returns may be taxed at different rates. As covered in the tax considerations chapter, dividends and capital gains may be taxed differently.
Let’s work through an example:
An investor in the 24% tax bracket purchases 100 shares of stock at $80 per share. Over the course of a year, they receive $2 quarterly dividends (per share). The investor sells the stock at $90 per share exactly one year after it was purchased. What is the after-tax return?
This investor has two types of return:
Qualified* cash dividends for this investor are taxable at 15%; only those at the two highest tax brackets (35% and 37%) are subject to the 20% dividend tax rate. Short-term capital gains are taxable at the investor’s tax bracket, which is 24%.
*Nearly all income paid from equity securities is considered qualified and subject to 15% or 20% taxation. There’s one exception - real estate investment trusts (REITs) pay non-qualified dividends, which are taxable at the investor’s income tax bracket. Again, you can revisit the tax considerations chapter if a refresher is necessary.
Even though the investor bought 100 shares, a per-share approach keeps the math clean:
Applicable tax rates:
To convert each return to an after-tax amount, multiply by (100% − tax rate):
Now compute after-tax return using the same structure as total return:
Here’s a video further breaking down after-tax return:
In the late 15th century, Italian mathematician Luca Pacioli developed a simple way to estimate how long it takes to earn a 100% return* on an investment. This method is called the Rule of 72.
The Rule of 72 isn’t perfectly precise (more complex math is needed for exact results), but it’s a quick way to estimate how fast an investment can double.
*Making a 100% return on an investment is the same as doubling the investment. For example, assume an investor makes a $10,000 investment. A 100% return would be an additional $10,000, increasing the investment’s value to $20,000 (2x the starting amount).
The first formula estimates the time needed to double:
*When using this calculation, do not enter the rate of return on a typical decimal basis. For example, if the rate of return is 7%, you will enter ‘7’ into the denominator, not ‘0.07.’
Try it:
An investor believes they can attain an annual rate of return of 9% on an investment of $100,000. Assuming their goal is to grow the funds to $200,000 for a down payment on a home, how long will it take to reach the goal?
Can you figure it out?
Answer = 8 years
With an expected rate of return of 9%, use the Rule of 72:
The Rule of 72 can also estimate the annual return needed to double within a given time period:
Try it:
A customer of yours has $50,000 to invest in their daughter’s college experience. Their goal is to grow the funds to $100,000 before the child turns 18. Assuming the daughter is currently age 12, what annualized rate of return must they attain to reach their goal?
Can you figure it out?
Answer = 12%
The daughter is 12 now, and the funds must double by age 18, so the time period is 6 years:
Rule of 72 questions can also involve doubling more than once. For example:
An investor recently received a $50,000 bonus from their employer and planned to invest the funds into the market. Their goal is to reach $200,000 within 8 years. What annualized rate of return is required to reach their goal?
Can you figure it out?
Answer = 18%
The investor wants to double the money twice in 8 years ($50k → $100k → $200k). That’s equivalent to doubling every 4 years. Now apply the Rule of 72:
After you calculate a portfolio or security’s return, it’s often compared to a relevant benchmark index. For example, large-company stocks are commonly compared to the S&P 500 index. If a stock is up 15% for the year while the S&P 500 is up 10%, the stock is outperforming the benchmark by 5%.
An index tracks the market prices of a pre-determined group of investments. For example, the S&P 500 tracks 500 of the largest U.S.-based publicly traded companies, including Apple, JP Morgan Chase, and Amazon.
In general, an index reflects the average change in market prices for its basket of securities. However, indexes can weight holdings differently. For example, changes in Amazon’s price affect the S&P 500 more than changes in Alaska Airlines stock because Amazon’s market capitalization is roughly 200 times larger. This is the basic idea behind weighting: larger companies typically have a larger impact on the index.
Indexes typically use one of two weighting methods:
These are the relevant indexes to be known for the exam:
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