How Do You Calculate Investment Returns When You Keep Adding Principal?

In this video from the Motley Fool Answers podcast, Alison Southwick and Robert Brokamp welcome Sean Gates to the show as they answer listener questions.

One Foolish investor faces the complex problem of how to calculate the return on investment on a balance you are steadily adding more cash to -- the magic phrase is "time-weighted returns". 

A full transcript follows the video.

This podcast was recorded on Dec. 13, 2016.

Alison Southwick: The next question comes from -- they're just going by the name Jester. I don't know how I feel about reading this word for word.

Robert Brokamp: It's the way our audience feels about you.

Southwick: OK, here we go. "Oh, great goddess Alison and fellow Alison-worshipper Bro."

Brokamp: Well, let's not go too far, here.

Southwick: "I beseech thee for thy wisdom. I am but a poor, humble dollar-cost averaging investor. I know that if I'm not beating the market, then I'm better off just buying an index fund, but I'm not sure how to calculate my returns. If I invest $1,000 and I make 10%, then I have $1,100. Yeah." By the way, that's his yeah, not my yeah. I know I'm prone to saying yeah, and things, while I'm reading these letters.

Sean Gates: An important distinction.

Southwick: "All is well until next month when I deposit $900. Now my account is worth $2,000, only $100 of which is profit, so my return drops to 5%. Noo!"

Brokamp: He wrote that, too!

Southwick: "I know the market hasn't passed me by when all I did was deposit more money, right? How do I calculate my actual return on investment when I'm beefing up my account at regular intervals and amounts? Thanks and stay Foolish."

Brokamp: This is actually a pretty complicated question, and it's a very good question, because you want to know your actual returns and not just based on the money put in. A different problem was made very popular by the Beardstown Ladies.

Southwick: I was going to say. Are you going to talk about the Beardstown Ladies?

Brokamp: Do you remember the Beardstown Ladies?

Gates: No.

Brokamp: So they were an investing club ...

Southwick: Right around when The Motley Fool was becoming a thing, too.

Brokamp: Yes. They were founded in 1983, and from 1983 to 1994 they had returns of 23.4%.

Southwick: And these are like ladies.

Brokamp: Yes. It's Beardstown, Illinois. So they wrote a book. It became a best-seller and became very famous until a couple of journalists figured out that actually what they were doing is they were counting the money they put into the account every month as returns. And then once the returns were audited, it turns out that they actually earned just 9.1% a year, considerably less than the 14.9% on the S&P 500.

Southwick: Still not bad, but ...

Brokamp: Yes ...

Southwick: ... not that great.

Gates: Not that great.

Brokamp: Not that great. So you don't want to do that. You don't want to count the money you put in or, if you're retired, the money you're taking out as part of your returns. The magic word you need to Google is "time-weighted returns". That's what you are looking for, and I can give you a couple of Fool articles to look for. One is Computing Your Investment Returns, Redux and Keep Track of Your Returns. Both of those are by Matt Richards. They're actually over a decade old, but they do a great job of explaining how to do this.

In those articles, he mentions a spreadsheet that's no longer available, but one of our current analysts, Jim Mueller, actually created a spreadsheet on Dropbox and maybe we could tweet that out.

Southwick: Oh, yeah!

Brokamp: So you can get the spreadsheet and put your numbers in -- when you put your money in and when you take money out -- and it will calculate the time-weighted returns for you.

Southwick: Oh, nice. So the easy answer is we'll get it to you.

Brokamp: We'll get it to you. And also, ideally, your brokerage account is doing that for you, as well, but they don't always do that so you just have to keep an eye on it.

Gates: And I think the key distinction, there, is that most brokerage firms allow you to run multiple variants of your performance. There's the regular rate of return or the time period return, and then there's the time-weighted return. You can usually run a report where you run the time-weighted return of your account, so you can just easily see it from within your own account.

And it's funny that you mentioned that story, because a lot of the times when I was back in the business, people would come to me comparing their 401(k) returns to the returns they were getting in our investment portfolio, and the 401(k) always looked phenomenal, but it was because most 401(k)s report it including contributions ...

Southwick: Oh!

Gates: ... so everyone always assumes their 401(k) is doing gangbusters when it often is being reported as including the contributions that you make as part of its total return.

Brokamp: Look! It's up $25,000. Of course, I put in $18,000, but hey! That's really the secret to investment success. Just keep putting money in your account.