In Part One of this series, we talked about how to compute investing returns, and we began the process of setting up a spreadsheet to help us do it properly. Let's continue.

Now we'll buy some stock. Remember, we're treating our holdings as if we were managing them as a fund -- in this case the "You Fund."

Let's say we bought 150 shares of **Microsoft** (NASDAQ:MSFT) at $25, and 150 shares of **Yahoo!** (NASDAQ:YHOO) at $37, investing $9,300 (plus $20 in commissions) of our $10,000 -- leaving $680 in cash. We make *no entry* in the spreadsheet regarding this purchase. We decided in Part One that we are only tracking cash inflows and outflows. Purchases and sales within the account do not affect our computation of returns.

A month from now Microsoft is trading at $26, and Yahoo at $39. We'd like to know how we're doing, so we add a line to our spreadsheet, giving us this:

Date |
Cash in/ | Start shrs. | Shrs. in/ out | End shrs. | Acct. value | NAV* |
---|---|---|---|---|---|---|

5/19 | $0 | 0 | 0 | 0 | $0 | $10.00 |

5/20 | $10 | 0 | 1000 | 1000 | $10.00 | $10.00 |

6/20 | $0 | 1000 | 0 | 1000 | $10.43 |
$10.43 |

The entry for 6/20 is a full memo entry that allows us to compute our returns. For 6/20, since no cash went in or out, we entered that amount as $0. Start shares was brought down from the previous row's end shares. The start shares entry is equal to the end shares from the previous entry. Since the cash in/out entry is $0, shares in/out is 0, and the end shares for 6/20 is the same as the start shares. We enter the account value of $10,430, which is 150 times $26 for the Microsoft stock, plus 150 times $39 for the Yahoo! ($9,750 total), plus the $680 in uninvested cash, in the "account value" column. (Presumably we just took the total value for our account from a statement or Web page and plugged it in here.) Finally, the NAV is computed as the account value divided by the end shares, or $10.43.

So far, so good, and not terribly complicated. The shares in our hypothetical "You Fund" have risen from $10 to $10.43, for a profit of 4.3%. This makes sense, since our cash deposit into the account was $10,000, and the account is now worth $10,430. Note that these calculations include the uninvested cash. If we had calculated our return solely based on our Microsoft and Yahoo! investments, we might have been tempted to say that we were up $430/$9,300 = 4.62%. But that would be wrong! Our uninvested cash, earning 0%, drags our return down to 4.3%.

The 4.3% return is our return to date, of course, and not an annualized return like those reported by mutual funds. To get an annualized return, we'll take our return to date, divided by the fraction of the year that has gone by. In this case, 4.3% / (31/365) = 50.63%. Note that this is an uncompounded rate of return, which is the conservative approach, since compounding the return for such a short period of time is probably not appropriate. In fact, *annualizing* the return for such a short period of time, as we've done above, is *definitely* not appropriate, but I know you'll do it anyway, so you might as well do it properly. Just don't take it too seriously, because it does not provide credible evidence regarding your likely investing performance -- yet.

Since the entry for 6/20 is there only to allow us to calculate the returns through that date, we can leave it in the spreadsheet or not, as we see fit. For now, we'll leave it. In fact, if you make a new entry for each business day, you'll end up with a full, graphable record of your returns. Pretty cool!

Three more months go by, and on Sept. 20 we decide to pull $300 out of the "You Fund." Our stocks are still trading at $26 and $39, so the value of the account has not changed. This is a "cash going out" entry. It is a two-line entry, like the "cash coming in" entry. As with the "cash coming in" entry, we first need a memo entry that shows the NAV for the night prior to the withdrawal, in order to determine the price of the shares we "sold." In this case the NAV (again computed as the account value divided by the number of shares) is still $10.43. We make an entry in the spreadsheet for the previous day, and another for today:

Date | Cash in/out | Start shrs. | Shrs. in/out | End shrs. | Acct. value | NAV* |
---|---|---|---|---|---|---|

5/19/05 | $0 | 0 | 0 | 0 |
$0 |
$10.00 |

5/20/05 | $10 | 0 | 1000 | 1000 | $10.00 | $10.00 |

6/20/05 | $0 | 1000 | 0 | 1000 | $10.43 | $10.43 |

9/19/05 | $0 | 1000 | 0 | 1000 | $10.43 | $10.43 |

9/20/05 | $.-3 | 1000 | -28.76 | 971.2 | $10.13 | $10.43 |

To create the cash out entry we enter the date and the amount of cash going out (as a negative number) in the first two columns. As always, start shares is equal to end shares from the previous row. Shares out is equal to cash out divided by the NAV from the previous row. End shares is start shares plus shares out. With shares out as a negative number, our end shares are less than the start shares. For account value, we again enter from a statement or Web readout, and we compute NAV as account value divided by end shares.

Here we see how the time-weighted internal rate of return (TWIRR) method factors cash out of the computations. (In Part One, we said that TWIRR is a standard method for determining a rate of return that properly accounts for cash moving in and out of the account.) Note that the removal of cash does not affect the NAV. We simply sell a number of shares whose value is equal to the amount of cash withdrawn, and remove them from the account. The NAV doesn't change, which means our returns don't change, except for the fact that more time has elapsed.

Two months later, we've reached the six month mark. Our investments have blossomed; Microsoft is at 28, and Yahoo at 41. Here's what our spreadsheet looks like now, with another memo entry added:

Date | Cash in/out | Start shrs. | Shrs. in/out | End shrs. | Acct. value | NAV* |
---|---|---|---|---|---|---|

5/19/05 | $0 | 0 | 0 | 0 | $0 | $10.00 |

5/20/05 | $10 | 0 | 1000 | 1000 | $10.00 | $10.00 |

6/20/05 | $0 | 1000 | 0 | 1000 | $10.43 | $10.43 |

9/19/05 | $0 | 1000 | 0 | 1000 | $10.43 | $10.43 |

9/20/05 | $.-3 | 1000 | -28.76 | 971.24 | $10.13 | $10.43 |

11/20/05 | $0 | 971.24 | 0 | 971.24 | $10.73 | $11.05 |

We're doing pretty well! After six months, we are up 11.0478/10 minus 1 = 10.48%. More importantly, our method has correctly computed our returns, despite a cash withdrawal along the way.

Another month goes by, and during that month we sell our shares of Microsoft for $31 each, net of commission. This adds $4,650 in cash to our account, which brings us to a total of $5,030 in cash when we add the uninvested $380. Meanwhile, Yahoo! is at $43. Here's our spreadsheet now:

Date | Cash in/out | Start shrs. | Shrs. in/out | End shrs. | Acct. value | NAV* |
---|---|---|---|---|---|---|

5/19/05 | $0 |
0 |
0 | 0 | $0 | $10.00 |

5/20/05 | $10 | 0 | 1000 | 1000 | $10 | $10.00 |

6/20/05 | $0 | 1000 | 0 | 1000 | $10.43 |
$10.43 |

9/19/05 | $0 | 1000 | 0 | 1000 | $10.43 | $10.43 |

9/20/05 | $.-3 | 1000 | -28.76 | 971.24 | $10.13 | $10.43 |

11/20/05 | $0 | 971.24 | 0 | 971.24 | $10.73 | $11.05 |

12/20/05 | $0 | 971.24 | 0 | 971.24 | $11.48 | $11.82 |

Excellent! After seven months we are up 18.2%, or roughly 31.04% annualized (15.1 / (214/365)). Note that nowhere in our spreadsheets are our buys and sells listed explicitly. As I mentioned earlier, all that matters is the total value of the account at any given time, not when individual buys and sells are made, or at what prices.

Continuing the process is simply a matter of making new entries whenever cash goes into or out of the account, and putting in the occasional memo entry to check your returns. If you want a continuous record, make an entry that includes each day's end-of-day account value.

In fact, I think the best way to continue the process is to do just that. Make an entry each day, indicate any cash in or cash out, and update the account value. This combination of memo/cash entry serves both functions, and gives you an end-of-day NAV showing each day's account value.

While maintaining this spreadsheet may seem difficult at first, you'll quickly get used to it. Once you get in the habit, you'll always know your true returns, and you'll be able to brag about them with pinpoint accuracy the next time you're at a cocktail party.

I have provided a sample spreadsheet here that you can use as a basis for your own measuring. Good luck!

*If you missed* Part One * of our series on calculating your investment returns, click here to catch up.*

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*Fool contributor Matt Richards is President of Richards Asset Management, LLC. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. Matt appreciates your feedback. To read some of his other writings, visit his website. The Motley Fool is investors writing for investors.*