When measuring portfolio performance, simple averaging doesn’t work. If you gained 100% in Year 1 then lost 100% in Year 2, you’d average 0% annual return. In reality, you’d have lost it all. Compound annual return is more accurate. But what do you compare it to? The S&P 500 index is commonly used, but VTI fund’s 3,500 stocks is better. Adding or removing money mid-time frame makes things even more complicated. Internal rate of return is often treated as gospel, but it has flaws. There’s also an argument about time-weighting versus dollar-weighting. Ultimately, no single method is perfect, and money managers often use the one that makes them look good.
Key Takeaways:
- If your investment increased by 100% in Year 1, then declined 100% in Year 2, average return would be 0%, but you’d actually have lost everything.
- Adding or withdrawing money in later years makes calculating average return tricky.
- Time-weighting treats all years equally, while dollar-weighting places more value on years with more money in play.
“A common practice is to compare a U.S. stock portfolio to the S&P 500 index. But there’s a better ruler: an index of 3,500 stocks. The way to track that index is to keep an eye on the Vanguard Total Stock Market Index Fund, available as an exchange-traded fund with the ticker VTI.”