In analyzing your portfolio, there are many ways your portfolio makes an income and increases in value. In the sections below, we discuss each of the variables in calculating your portfolio’s investment return.

1.1.1 Yield

Yield is often applied to either interest earned from a bank, or bonds and bond mutual funds. In reference to a bank account or a bank certificate of deposit, yield primarily refers to the amount of interest you’ll receive on a certificate of deposit or other type of account. The bank is required to tell you in advance what you’ll be earning.

As described above in the Section on bonds, a bond yield is the annual interest payment relative to the price paid for the bond. This will vary from the coupon rate of the bond in that the market price of the bond will change as economic conditions change.

1.1.2 Interest

This is similar to yield. In the investment world it refers primarily to bonds. If you buy a $10,000 bond that pays 8% interest, you’ll receive interest payments of $800 per year until the bond matures, at which time you get your $10,000 back. In most cases the interest amount is stated in advance, so you know going in what your return on investment will be.

1.1.3 Dividends (stocks)

A stock dividend is a quarterly check that some companies pay to shareholders. Dividends are declared each quarter and can go up or down but usually don’t change very much. Similar to bond interest, you can usually count on stock dividends, especially when you invest in large, established companies that take their responsibilities to shareholders seriously. Compared to capital gains (see below), dividends usually represent a very small part of a shareholder’s overall return on investment. High-growth companies generally don’t pay dividends at all, preferring to reinvest any extra cash back into the company.

1.1.4 Capital gains

This is the most lucrative part of investing. It’s also the most uncertain. If you buy 100 shares of a stock at $25 and sell those shares at $40, you’re investing $2,500 and getting back $4,000, minus trading costs. The difference of $1,500 is called a capital gain. The opposite of a capital gain is a capital loss. This would happen if you bought the stock at $25 and sold it for $15. Whenever you invest in a stock, you can never know in advance what your capital gain (or loss) will be. This is the part that scares people about stocks. It’s also where your research will come in handy. But the fact remains that no amount of knowledge will enable you to predict stock prices in advance. Investing in stocks is always based on an educated guess; it’s never a sure thing.

1.1.5 Dividends (mutual funds)

Some mutual funds call their distributions to shareholders “dividends,” even though they are primarily made up of capital gains from the sale of stocks in the portfolio. These “dividends” cannot be estimated in advance and are just as uncertain as any capital gain (or loss) you might receive from owning individual stocks.

1.1.6 Total Return

Your portfolio’s total return is the total value of your portfolio at an end date relative to the total value at its start date, including all income and capital gains as illustrated in the formula below:

(Ending Value – Beginning Value) / Beginning Value

Another similar way to calculate your portfolio’s total return is:

(Interest + Dividends + Capital Gains) / Beginning Value

In calculating your portfolio’s total returns, be careful to make sure that you account for any amount that you may add or subtract from your portfolio during the period in which your are calculating your portfolio’s returns.

1.1.7 Risk-Adjusted Performance

Over the past three years the Fidelity Government Income Bond Fund earned an average annual return of 10%. During that same period of time, the Fidelity Select Construction and Housing Fund also earned an average annual return of 10%. In making this type of comparison are we comparing apples to apples? Since the ultimate result was earning an average annual return of 10% some would say yes. On the other hand more seasoned investors realize that those who invested in the Select Construction and Housing Fund likely had a much bumpier ride. That being the case, how do you go about comparing mutual fund returns?

The most common way to compare the performance of mutual funds is to calculate their risk-adjusted return. In the following table, we take a look at the average return of Fidelity mutual over the past 10 years, by fund objective. In the third column we show illustrate the fund’s risk through the average standard deviation within that fund objective group. Note the high correlation between the fund’s risk and return.

Fidelity
Fund Group

Avg
Ann Ret

Std. Dev

Sector

10.00

23.77

Growth

8.74

18.82

Balanced

8.61

13.42

Income

6.24

4.75

International

4.22

16.80

Therefore, in the past, if a fund manager wants returns that will beat every other mutual fund, all the manager needs to do is subject their fund to an abnormally high amount of risk – but as we have seen in recent years, there is a cost to that risk. In this illustration, we graph out the data in the above table. Notice that the graph illustrates that for each unit of “return” you take on a disproportionately higher amount of risk. For example, for the average Fidelity Income fund, by dividing 4.75 into 6.24 you get – meaning that for each unit of risk, you get a 1.32 percent return. But if you look at the average Fidelity Growth Fund, you get a 0.46 percent return for each unit of additional risk. Nonetheless, it is probably not fair to compare Income to Growth Funds given their relative performance over the past three years. A better comparison is the relative performance of Growth and Balanced funds. There was a negligible difference in performance between Growth and Balanced funds, but notice that there is significantly more risk associated with the average Fidelity Growth fund.

To complete our look at risk-adjusted returns, let’s take a look at the Sharpe Ratio. Nobel Prize winning Economist William F. Sharpe developed one of the best ways of measuring risk adjusted-performance. Sharpe’s Ratio quantifies a fund’s return relative to total risk. The following formula illustrates the Sharpe Ratio:

As you can see in the above formula, the Sharpe Ratio looks only at the return above the risk-free rate and adjusts that amount for each unit of additional risk. The Sharpe Ratio can be found in most mutual fund databases and analysis tools, such as on Morningstar or Yahoo Finance.

1.1.8 Past performance and Future Returns

Of course both of the above methods of measuring a fund manager’s performance are based on historical data. How did they perform over the past three years? Since we know that past performance is no guarantee of future returns, this data is almost meaningless in determining which mutual funds to choose for your portfolio.

To determine a mutual fund’s future return relative to risk, the MutualFundAlliance.com developed a series of models that forecast the monthly returns of every Fidelity, Vanguard, Janus, and T Rowe Price mutual fund and adjust this forecasted return returns for risk using a risk-adjustment technique similar to the Sharpe Ratio above. In Chapter 5, we discuss the alternative ways of choosing mutual funds for your portfolio.