How to Evaluate Your Returns

Here's an excellent question from a reader:

In your article, you mention that an investor should outperform the market. But how can I track this? How do I know how well the market has done from a given date to present? I cannot find this on any website.

Basically, what you need to do is check the historical prices for the stock market. First, of course, you will need to decide what you'll consider "the stock market." One good measure is the S&P 500 index, as it includes 500 of America's biggest and best companies.

That may not seem enough; after all, there are many thousands of companies out there, but these 500 do make up 75% or more of the entire market's value. In other words, they're really big.

You might also choose to use the Dow (Dow Jones Industrial Average), as it has represented the market for decades in the media. But note that it includes only 30 companies, such as 3M (NYSE:MMM), Pfizer (NYSE:PFE), and Caterpillar (NYSE:CAT).

Another option is tracking the total stock market, via the Dow Jones Wilshire 5000 index, which includes nearly every publicly traded company in America, including many tiny ones.

Once you've chosen your market-representing index, look up its historical prices. You can do that at Yahoo! Finance, Fool.com's CAPS/Quotes nook, and many other sites. At Yahoo!, start typing the index's name into the quote box, and it will quickly give you some options. Choose the right one, and off you go! (You can also access historical prices at the indexes' websites.)

Crunching numbers
Now that you're ready, let's run through an example. Let's say that since June 14, 1991, your portfolio has grown from $20,000 to $120,000.

Divide $120,000 by $20,000 and you'll get 6. Your portfolio sextupled, or multiplied six times. That doesn't translate to a gain of 600%, though. (After all, doubling is a gain of 100%, not 200%.) To get the percentage, you need to take the growth multiple, subtract 1, multiply by 100, and then tack on a percentage sign. So, 6 minus 1 is 5. And 5 times 100 is 500%. So, from 1991 to 2008, your portfolio increased in value by 500%. Good show!

But here's the rub -- is it really a good show? For all you know, the market might have advanced 900% in that period, in which case you'd have been better off investing in something else. So let's see, shall we?

Source: Yahoo! Finance. Past stock prices adjusted for dividends.

In that light, a 500% gain looks pretty good. When you look at the S&P 500 over the past 17 years, you get a growth multiple of 5.04, or total growth of 404%. You did really well by comparison!

Annualizing
If you're not scared of a little more math, you might want to annualize those numbers and get an average annual growth rate over the period.

To do this, we first need to figure out the time period involved. From 1991 to 2008 is 17 years, so we'll be taking the 17th root of the growth multiple. (If the time period were two years, you'd take the square root of it; if it were three years, the cube root.)

You'll need either a computer with a spreadsheet program or a calculator with a "^" button -- one that raises numbers to various powers. Raise the growth multiple of 6 to the 1/17th power, and you'll get 1.11. (It will help to first divide one by 17, to get 0.06, and raise 6 to that.) Now subtract 1, multiply by 100, and you've got 11% as your approximate average annual growth rate. For the S&P 500, raising 5.04 to the 0.06 power yields 1.10, or 10%.

Internal rate of return
Of course there are more complexities involved. For instance, odds are, you didn't leave your portfolio to grow for 17 years without adding to it over time. If so, then your overall return doesn't reflect just your investments' growth, but also the additional capital you poured in. To account for that, things get much trickier.

Learn more about the internal rate of return. Note that many online portfolio-trackers will calculate this for you.

You can learn even more here:

• Computing Your Investment Returns
• Keeping Track of Your Returns
• Stock Advice That Will Change Your Life
• The Greatest Secret of All