Since Matt and I dueled on Microsoft last week, I think his article about it yesterday was cheating a bit, but I'll bite my tongue and let it slide this time. Instead, it's time for our monthly $500 investment, and I'd like to talk about that today.
Every month, we add $500 cash to our real-money portfolio, which is held in a brokerage account at American Express. This month, it's Phil's turn to pick the stock we'll buy, and next week, after we get past the earnings season crunch, he'll outline the rationale behind his decision.
Adding $500 to our portfolio each month is a good thing. Fans of Drips know about "dollar cost averaging," which means that if you invest a fixed dollar amount at regular intervals in something with a randomly fluctuating price, your dollars buy more shares when the price is low and fewer shares when the price is high, so your average cost basis per share winds up BELOW the average price of all those fluctuations. You bought more when it was down, and less when it was up, all without having to actually know whether prices would go up or down. Neat trick, that.
We're not exactly dollar cost averaging into our stocks because we move our investment around from stock to stock, but we are making the same fixed investment whether the market as a whole is up or down. In the absence of a reliable way to predict the market, this gives us the best results we know how to get.
On the down side, that $500 of regular savings greatly complicates tracking our portfolio returns. The performance of a fixed amount of money invested for a known amount of time is math you can do on a pocket calculator, but if you make different investments at different times, you need to hand the calculation over to a computer.
Fortunately for us, if you look at our nightly numbers, you can directly compare how well the Rule Maker has performed versus the S&P 500 -- on an apples-to-apples basis. The "S&P 500 (DCA)" tells us what our return would have been if we had bought the S&P 500 instead of buying the stocks that we've bought. As of tonight, the Rule Maker Portfolio has returned 65.77% since its inception on February 2, 1998. If for each time we purchased a Rule Maker, we instead invested our cash in the S&P 500, our return would be only 26.75%. In other words, our investments have more than doubled the S&P's performance on average.
Although it's not used by our portfolio, the most mathematically sophisticated method of figuring out how well your investments do is found using a calculation called the "internal rate of return." The key feature of this method is that it captures the time value of money. The National Association of Investment Clubs (NAIC) sells portfolio tracking software that can calculate an internal rate of return, and most spreadsheet programs can do it via the "XIRR" function.
To use either, you enter a series of dated deposits and withdrawals for your portfolio, listing all the money you've put in and taken out since you opened the thing. It's similar to balancing your checking account. The current value of the portfolio is entered as one big withdrawal dated today, as if you were closing out the account. Then you tell the spreadsheet to do a XIRR, and kaboom, you get your annualized percentage return. (The Fool recently had a workshop on portfolio tracking using spreadsheets that you might find useful.)
If you're curious as to how an Internal Rate of Return is actually calculated, it's a binary search for the interest rate at which the current value of a series of discounted cash flows is zero. Yes, it's about as complicated as it sounds. I wrote a program to do it once, and I can assure you it's NOT the kind of thing most people would want to try to do on a pocket calculator. You want to have a computer do it for you.
The Rule Maker Portfolio uses a different and, in fact, more conservative method of calculating returns called "cash IN / cash OUT accounting." This method simply divides the current portfolio value by the amount of cash that was invested originally. As we make our monthly $500 additions, each new $500 is added to the base of invested capital. Like the IRR, this method nicely filters out the additions to the portfolio so they don't distort the returns our investments get, but in doing so it hides the real reason we add $500 each month in the first place. (By the way, no portfolio accounting method is perfect in every way. There was a good thread on this topic last summer in the Rule Maker Strategy discussion board.)
The fact is, there's a big difference between the portfolio's rate of return and the growth of the portfolio itself. The investment returns show how well the investments we've put our money in have performed, and in an investment column it's the number we use almost exclusively when talking about the growth of our portfolio. But it's not the whole story.
The Rule Maker portfolio has grown considerably faster than the investment returns we report at the bottom of each column because we're adding money to the thing all the time. The fresh savings we add to our cash horde do, in fact, increase the size of our portfolio. They are an extremely important part of our overall strategy to accumulate an enormous heap of filthy lucre, and we usually don't emphasize them enough.
The actual rate at which your portfolio is increasing is the most important result of all, and savings contributes to that as directly as investment returns. It's possible to get rich by simply depositing enough money in a bank account, a little at a time, year after year. That's definitely the hard way to do it, but it works.
Every $500 we add to the portfolio is there, basically, to remind us of this.
- Oak
