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Author: BruceCM Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 75381  
Subject: Re: Is compound interest working? Date: 5/12/2010 1:30 PM
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Compounding is the condition of an investment gaining in value over a period of time (usually a year or 'annualized'), the gain is added to the starting amount, and this becomes the new starting amount for the next year, and so on and so on, year after year. Its the case of earnings themselves earning a return over future years. In the example you've given of JNJ, the 7.4% could be the average annual rate of return over the period you've held it, assuming the dividends are reinvested. This is also the the way mutual funds report their performance. Sometimes returns are reported as 'gross returns'. This would be the total % return over the period you've held it, and is not annualized. You'll need to check with your brokerage to see how this value is reported.

There are two factors to consider when trying to quantify your 'rate of return'.....the amount and the timing of your investments. The best measure of return is weighted for timing AND dollar amount, or, "time and dollar weighted" return, also referred to as Internal Rate of Return (IRR).

There are a number of on-line calculators I'm sure others can provide links to. But for your personal use, the two best ways to calculate your own IRR is through the XIRR function in Excel, or, as I do, with a hand held financial calculator.

As to comparing your brokerage account's return, assuming you're holding stocks and no bonds, you'd need to compare it to a comparable 'standard', the most popular being the S&P 500 index. So, for example, on Jan 1, 2010, you hold 4 stocks in your brokerage account with a total beginning value of $20,0000, you received dividends during the year that are automatically reinvested, and the value of the brokerage account is $22,000 at the end of the year, the 2010 annualized rate of return will simply be (22,000 - 20,000)/20,0000 = 10%.

But lets say you add to and withdraw from the account during the year, and lets say this happens at the beginning of the month. To calculate the IRR, the amount and timing of these cash flows would need to be taken into account. So using Excel's XIRR function, you'd enter:

1/1/2010 (20,000)
2/1/2010 -
3/1/2010 500
4/1/2010 (1,000)
5/1/2010 (1,000)
6/1/2010 -
7/1/2010 -
8/1/2010 500
9/1/2010 (1,000)
10/1/2010 -
11/1/2010 (1,000)
12/1/2010 500
1/1/2011 24,000

IRR 7%

When putting in values, by convention, negative numbers represent $$ you're putting into the account (think of them as leaving your househlod), with positive numbers represent withdrawals (bringing them back to your house), with the 1/1/2011 representing the account value as of that date (ok, you're not withdrawing this amount, but for calculation purposes, you're treating it as though you are)

If over this period, the S&P 500 returns 5.2%, then your portfolio beat the S&P 500 for 2010.

Now, try this with your Roth IRA or with your JNJ stock. Be sure to use the 'date' function when entering the dates of deposits to the Roth...and you may not have any withdrawals, so all entries will be negative except for the end of the period you are calculating your return through, and it will be positive.

BruceM
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